Mortgage Interest Rates
An explanation of how fixed and variable interest rates are determined and how to choose the best option for you
Variable Interest Rates
The Bank of Canada’s overnight lending rate sets the cost for Canada’s banks to borrow money from each other at the end of each business day. It is adjusted on predetermined meeting dates throughout the year as a way to control inflation.
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Prime rate, which is what financial institutions use to set interest rates for variable mortgages, loans, and lines of credit, is primarily influenced by the Bank of Canada’s overnight lending rate. When the overnight rate goes up or down, Prime rate usually follows. Variable rates are expressed as Prime plus or minus a certain amount.
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We say variable, but there are actually two types: variable rate mortgages and adjustable rate mortgages. Variable rate mortgages have payments that stay the same as Prime changes, so the amortization (the total length of the mortgage) fluctuates when Prime moves. Adjustable rate mortgages have payments that change as Prime changes, which keeps the amortization on track.
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If you choose a variable rate mortgage and decide to break it before the term ends, the penalty is typically equal to three months of interest.
Fixed Interest Rates
Fixed rate mortgages work differently. Instead of following the Prime rate, they follow the trends of the corresponding Government of Canada bond yields. For example, the five year fixed rate for a mortgage generally follows the five year bond yield. Government bonds are low risk investment products, and the bond yield is the annual return on those investments expressed as a percentage.
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If you decide to break a fixed rate mortgage before the term ends, the penalty will be the greater of three months of interest or the Interest Rate Differential (IRD). The IRD is calculated based on the difference between your current mortgage rate and the lender’s current rate for a similar term, applied to the balance and remaining time left in your term.
Essentially, it compensates the lender for the interest they lose if you end your mortgage early.
Variable vs Fixed
Typically variable rates are lower than fixed rates, but for the last little while it has actually been higher than most fixed terms. Historically, variable has outperformed fixed as you can see here:
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But choosing variable or fixed entirely depends on a person's individual situation and risk tolerance!
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When choosing between a variable and fixed rate mortgage, it is important to consider the advantages and disadvantages of each.
A variable rate mortgage allows you to benefit from market movements, meaning that if interest rates decrease, so will your payments. However, if interest rates increase, so will your payments.
On the other hand, a fixed rate mortgage provides stability and predictability; your payments will remain the same regardless of changes in the market.
Ultimately, it is important to consider your financial situation and risk tolerance when deciding between the two.