How to pick Fixed vs Variable mortgages

How are mortgage rates determined?

Recent interest hikes from the Bank of Canada in response to the staggering inflation prevailing in the economic market have left home buyers wondering what kind of mortgage is the best available option to them.

In order to answer this question, we have to assess the situation from different angles.

As a potential home buyer, you are obliged to make informed decisions as to what kind of mortgage is the most suitable. First, you have to understand the options available for you and how their rates are affected. 

Fixed and variable mortgages are the two most popular financing solutions offered to regular home buyers. A fixed-rate mortgage triumphs over the variable one when the financial market is predicated to be turbulent ahead. 

The fixed-rate is not immediately affected by the overnight rate set by the Bank of Canada ( BOC)whereas it closely follows the mortgage bond rate exchanged in the secondary market.  Fixed mortgages, offered by banks, are rarely kept by them and they are often sold to investment banks and government agencies where the mortgages are packaged into mortgage bonds and issued to the secondary market. Just like any other investors, mortgage bond investors expect a rate of return, and the return comes from the mortgage interest paid by the borrowers. Therefore, the higher the return the investors are looking for, the higher the interest rate the bank will have to charge. 

The variable-rate mortgage - the interest rate fluctuates with the market - shows a clear advantage when the financial market is underperforming and is expected to enter into a lasting period of recession. The rate for such mortgage strictly ties with the prime rate set by financial institutions and the prime rate has a positive relationship with the overnight rate set by the BOC.

How do you decide which mortgage to take?

Given the rampant interest hikes carried out in the recent market, Nobody has a crystal ball in light of how much higher the rate will eventually reach, thereby making people panic and lost in the process of mortgage applications. Now there are a few things you must know to help you get back the peace of mind.

Let’s first take a look at the interest difference, spread, between variable and fixed mortgages. “Spread” is the interest difference between fixed and variable mortgages, a common financial term that you have to pay attention to. Today, the typical rate of a variable mortgage hovers around 2.3 to 2.6 percent, while the fixed rate is as high as 4.89 percent. The spread, the difference between the fixed and variable rates,  therefore, is approximately 1.6 percent. 

Now, as a borrower who is rate-sensitive and bound to withdraw the best borrowing solution, you have to calculate your risk tolerance and predict the future market outlook. Let’s take the current rate as an example. Given the current spread sitting at 1.6%, 160 basis points (1% is equivalent to 100 points), the changes of fixed mortgage rate quickly outcompeting the variable one is slim. However, you will still have to ask yourself two questions: 

  • How risk-averse are you? 

For those risk-averse investors, the best approach, especially during times of high volatility, is fixed mortgages. Although you will have to pay a premium for the stability over the next five years, you are guaranteed peace of mind. On the other side, for those investors who are willing to accept the underlying risks associated with the turbulent market, settling with a variable mortgage remains possible.

  • What’s your prediction of the future mortgage market? Will there be another significant rate hike or will the market cool down in a short while? How confident are you with your outlook? 

Even for those risk-takers, the ever-changing financial market is not a good place for gambling! Although the spread between the fixed and variable mortgages stays at a compelling 160 basis points, the big fives might further increase the prime rate to the extent in which the spread becomes so minuscule that you will be better off with a fixed term. Nevertheless, a variable term remains a solid option if the market becomes stabilized in a short period. Therefore, your prediction of the performance of the future market plays an important role in the success of your decision. 

Again, there is no such thing as a crystal ball, meaning that we have to come in equipped with a foundational understanding of the market. Being able to protect and isolate yourself from the ever-greater noise from the outside will grant you a strong foothold in this game.