Interest Rates & Types: Fixed, Variable or Hybrid

Let's review the various interest rate types. After you understand the basics, we delve into deeper waters on how mortgage interest rates are set, why they vary from lender to lender, and how to choose Fixed vs. Variable rate.

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When you apply for a mortgage, lenders may offer you options with either fixed or variable interest rates. Some lenders also offer a “hybrid” option that combines fixed and variable portions in the same mortgage..

Fixed interest rate mortgages

  • You will know in advance the amount of interest you will have to pay over the contract term, and therefore how much of the original loan amount will be paid off during the term, assuming no extra payments are made.
  • The interest rate is set or “fixed” when you apply for a mortgage. This interest rate remains the same for the entire contract term.
  • The amount of your regular mortgage payments is also fixed.

For first time home buyers, you may find it easier to manage a fixed interest rate mortgage, where your payment doesn't fluctuate.

Variable interest rate mortgages

  • The interest rate can increase or decrease during the term. The interest rate varies with changes in market interest rates, which can be difficult to predict.
  • How changes in the interest rate affect your payments will depend on whether your payments are fixed or adjustable:  

    Fixed payment, variable rate mortgage  

    You pay one set amount with each payment.  

    If the interest rate goes down, more of the payment applies to the principal and you will pay off your mortgage faster.

    If the interest rate goes up, more of the payment applies to interest, and less to the principal. Your lender may require you to increase your payments so that your mortgage will be paid off within the amortization period you had originally agreed to in your mortgage agreement.

    With fixed payments, you don’t know in advance how much of the principal will be paid off at the end of the term.  

    Adjustable payment, variable-rate mortgage

    Your payment amount changes if the interest rate changes. A set amount of each payment is applied to the principal, and the interest portion fluctuates depending on changes to the interest rate.

    If the interest rate goes down, your payments will decrease.

    If the interest rate rises, your payments also increase. This can make it more difficult to plan your mortgage payments over the term of the agreement, so you need to be sure you can adjust your budget to make higher payments.

    With adjustable payments, the amortization period stays the same. You can tell in advance how much of the mortgage will be paid off at the end of the term, because you pay whatever amount is needed to add up to the agreed amount.

Hybrid mortgages

  • Some lenders offer “hybrid” or combination mortgages—part of the mortgage is financed at a fixed rate and part is financed at a variable rate.
  • The fixed portion gives you partial protection in case interest rates go up, and the variable portion provides partial benefits if rates fall.
  • The portions may have different terms. For example, a hybrid mortgage may include a two-year term for the variable portion and a three-year term for the fixed portion.
  • Hybrid mortgages that include portions with different terms may be difficult to transfer to another lender.

A Word of Caution

The interest rates on variable rate mortgages are often lower than on fixed interest rate mortgages with the same term length at the point in time when you sign your mortgage agreement. This may make variable interest rate mortgages attractive in the short term. But, just because your dad or your grandpa says variable always beats fixed or the other way around, doesn't make it so.  Interest rates move in big economic cycles and it helps to develop a view point where things likely are in the "big picture."  When things were rock-bottom during the Covid-19 pandemic, there wasn't much room left for rates to fall further and locking in a fixed rate made a ton of sense.  Conversely, when inflation reared its ugly head after the pandemic, the pendulum swung the other way, and locking in a fixed rate at the top of the cycle became the next fear causing a shift to the variable rate mortgage product for borrowers okay with the risks and having sufficient finances to handle the fluctuations.

Rookie Mistake: thinking there is only one rate. There are many categories of rates quoted, and what you see in the window or ad is just "eye candy" or "window dressing" to attract your attention and you likely have no idea what it applies to.

Typically, the lowest mortgage rates that you see in the window are 5-year Variable-Rate "limited feature" mortgages for AAA+ borrowers for owner-occupied CMHC-insured home purchases. These limited feature no-frills-type mortgages often have onerous (and profitable for the lender) payout penalties or other back-end fees that kick-in in the event you have to break your mortgage before the term expires, or transfer your mortgage to a different lender upon renewal.

When you compare rates, the comparison needs to be apples-to-apples for the property-type and location you are trying to finance, whether you are buying or refinancing, whether the loan is CMHC-insured or not, and whether it is "full-featured" or has "limited-feature" attributes (and what that really means to you). Once you have drilled down to that level, you then want to make sure you compare variable-to-variable or fixed-to-fixed mortgage rates for equivalent terms. That's how to avoid making a rookie mistake. 

Here's a blog I wrote awhile back on the topic: What's the Best Mortgage Rate?

Sadly, when we (as an industry) post interest rates, these rates only represent a sub-set of what is really going on and the viewer has no idea what they are looking at unless they are educating themselves (like reading this stuff!). Many brokers subscribe to an information provider that publishes a big matrix of rates and where those rates apply and where they don't, but that would be confusing for people not in the industry. Instead, you can always establish a relationship with an experienced mortgage broker and trust them to advise you now, and to steer you straight throughout your home-owning future. 

A Fixed Interest Rate Mortgage May Be Better For You If:

  • you want to know that your interest rate and the amount of your regular payments are not going to change over the term of your mortgage.
  • you prefer knowing in advance how much of your mortgage will be paid off at the end of your term.
  • you think there is a good chance that market interest rates will rise over the term of your mortgage.

A Variable Interest Rate Mortgage May Be Better For You If: 

  • you are comfortable with the possibility that:
  • your mortgage payments could fluctuate (if you have adjustable payments).
  • your amortization period could fluctuate (if the amount of your payments is set and the interest rate changes).
  • you could pay more in interest over the term of your mortgage than you would have paid with a fixed interest rate.
  • you think that there is a good chance of interest rates dropping or staying the same over the term.

Fixed vs Variable Mortgage Rate?

Whether you are better off with a variable interest rate mortgage compared to a fixed interest rate mortgage or vice versa depends on whether the market interest rates go up, down, or stay the same during your term. This movement is difficult to predict and is heavily influenced by our domestic economy in Canada, the US economy, and global economic factors.

The Bank of Canada (which is not actually a bank but rather a federal government institution in charge of Canada's monetary policy and making sure we have a safe, sound financial system within Canada) sets the "Bank Rate" as a means of attempting to control inflation. volume knobThink of the Bank Rate as a big volume knob on the economy. As economic activity slows (say a recession), the Bank Rate is lowered to make borrowing cheaper so that people buy more cars and more houses, etc.  As demand for goods and services increase, so do their prices and this causes price inflation. What does the Bank of Canada do next? They increase the Bank Rate which causes interest rates hence the cost of borrowing to increase, which in turn should slow down borrowing and demand for goods and services.

Between 2000 and 2019, this Bank Rate has varied between 6.0% in 2000 down to 0.5% in 2009 (Great Recession) back to 2.0% in late 2018, back down to 0.5% at the Covid-19 breakout in spring 2020, then successive hikes in 2022 as inflation once again took hold. You can see those historical rates here. When they announce in the News that the Governor of the Bank of Canada is changing the Bank Rate, this is the number they are talking about. And please be clear, the Governor is NOT changing mortgage rates per se, but mortgage rates WILL change because cost of borrowing for chartered banks and mortgage lenders will change. Indeed, leading up to a Bank of Canada announcement, rates will already be on the move in anticipation.

Chartered Banks and other Mortgage Lenders typically set their 'Prime Lending Rate' (the one used to price variable rate mortgages) at 1.75% to 2.0% above the Bank (of Canada) Rate. For example, Prime for most banks and mortgage lenders was 3.95% in spring 2019 when the Bank Rate was 2.0%. Here are historical and current Prime Rates as published by MCAP, the largest independent (non-bank) mortgage lender in Canada.

All in all, if you are going to play in the Variable Rate mortgage space, you want a reasonable understanding of how "money markets" work and where our economy and rates in general are going, and please keep an eye on things in case you need to make adjustments. I like to watch the Canada 5-year Bond Yield, which has a strong co-relation to the 5-year fixed mortgage rate. The 5-year fixed mortgage is usually priced about 1.6% to 1.8% above the 5-year bond. The 5-year Canada Bond is also a close proxy to what is happening or going to happen with the Bank of Canada "Bank Rate" discussed above. My gut (in 2019) tells me that the "normal" 5-year fixed rate mortgage (when the Canadian economy is healthy and stable) will be priced in the 4.5% to 5.5% range. Compare that to today's rates and decide. (Update July 6, 2022, 5 year fixed rate insured is 5.04%)

A final warning: many variable rate mortgage contracts allow you to "lock-in" or convert to a fixed rate at any time, which is useful. BUT... (there is always a but!), 1) you are already captive to the lender so will you get their best rate (typically reserved for attracting new customers), and 2) if the market is on the move up, you may have already missed the boat - the opportunity to lock-in at the bottom of the rate cycle.

Competition in Variable Rates

The competition between variable-rate mortgage products for similar loan categories manifests in the differences between the discounts (or premiums) to Prime offered. For example, "Prime less 1.0%" means whatever Prime happens to be, your rate will track that and be 1% less. Prime less 1% (P-1%) is cheaper than Prime less 0.5% (P-0.5). P+1 is more expensive than P+0.5, and so on. For example, if you are in a Prime less 0.5% variable rate mortgage and at renewal time, and equivalent loans are being offered at Prime less 1.0%, you will want to renegotiate your discount/premium with the current lender or switch to a different more competitive lender, or perhaps you will want to "lock-in" to a fixed rate offering. 

Please be aware for any lender what penalties and fees apply if you have to break your mortgage before the term expires, which could easily erase any perceived interest rate savings you thought you'd capture going with the "lowest" rate lender.

Example: Fixed rate compared to Variable rate mortgage

In this example, we will review how a fixed vs floating analysis could be done. Please note however that this is a complex calculation with many moving parts and oversimplified for illustration purposes.

Samantha is buying a new home and requires a $200,000 mortgage. She is trying to decide between a fixed rate and a variable rate mortgage.

  • Samantha has chosen a 25-year amortization period, with the goal of being mortgage-free as soon as possible.
  • She decides to get a five-year term.
  • The lowest fixed interest rate she is offered is 4.0%, with a payment of $1,052 every month.
  • The current variable rate she can get is 3.5%, with a payment initially set at $999 every month.

The lender uses adjustable payments for its variable rate option and explains to Samantha that her payments could go up and down with the interest rates. If Samantha decides to go with a variable interest rate with adjustable payments, she will need to budget for the possibility that her mortgage payments may increase.

"In fact, when qualifying for mortgages in Canada with variable rates or fixed terms, the rules require that you qualify at a higher rate relative to something called the “benchmark qualifying rate” to make sure you don't bite of more mortgage than you can chew. This is called a Stress Test."

To help her decide if getting a variable interest rate is right for her, she looked at the following scenarios.

Comparing fixed or variable interest rate mortgages as interest rates rise
Scenario 1:
  • fixed interest rate mortgage
  • interest rate not affected by changes in market interest rates
Scenario 2:
  • variable interest rate mortgage
  • interest rate  increases by 2% during 5-year term
Scenario 3:
  • variable interest rate mortgage
  • interest rate increases by 4% during 5-year term

Scen#1 Interest Rate Monthly Payment Scen#2 Interest Rate Monthly Payment Scen#3 Interest Rate Monthly Payment
Year 1 4.0% $1,052 Year 1 3.5% $999 Year 1 3.5% $999
Year 2 4.0% $1,052 Year 2 4.0% $1,050 Year 2 4.5% $1,103
Year 3 4.0% $1,052 Year 3 4.5% $1,101 Year 3 5.5% $1,209
Year 4 4.0% $1,052 Year 4 5.0% $1,152 Year 4 6.5% $1,316
Year 5 4.0% $1,052 Year 5 5.5% $1,202 Year 5 7.5% $1,423
While the sample above is illustrative as to how payments might change over time, the proper analysis for each scenario should really be - given a constant monthly payment - what would my mortgage balance be at the end of a constant term, say 5 years. Then you compare the balances and determine if the risk of being wrong about the direction of rates is significant or not. We can do these calculations for you if you are using our brokerage for your mortgage needs. Here are some mortgage calculators if you want to try the DIY method.
My general advice if you want to play the variable rate game is calculate what your payment would be under a fixed-rate mortgage offering and make at least that payment every month regardless. The extra payment will go straight to the principal balance and reduce what you owe. If rates go up and more of your monthly payment starts going towards interest, you'll be happy you made the extra principal payments (built up a buffer) when rates where low.
Happy to be your mortgage adviser if there is a need.
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