Should I Go For a Variable or Fixed Rate Mortgage?

This is the perennial question especially when the Bank of Canada signals increases in its overnight lending rates. Often you will see experts saying things like “You should always go variable” or “Fixed gives you peace of mind.”

The answer is less straightforward than that and needs to consider your short-term and long-term goals and circumstances. This article outlines the criteria I use for making this decision. It is laid out as a set of criteria that you may choose from and assign the relative importance in your situation. While this article is written for real estate investors, it is generally applicable to individuals who have residential mortgages. For an overview of mortgages in Canada, also see reference [1].

This article focuses on the choice between variable and fixed rates for a fixed term (or closed) agreement with a financial institution. For example, a 5 year variable rate mortgage vs say a 5 year fixed interest rate mortgage. Note that mortgage products do differ between residential and commercial asset classes which will be part of your overall strategy. It is also important to note that nearly every mortgage product is negotiable in some way including the rate you pay.

Before committing to a mortgage option, a licensed mortgage professional should be consulted. Laws and mortgage products change continuously, and they will give you further and current input for your consideration. They can also work through rate negotiations and look for optimal mortgage features to help mitigate your defined risks. It is important to understand that a mortgage professional can only provide optimal options if they have full knowledge and understanding of your portfolio and what your goals are with each property.

Key Criteria

When deciding between variable vs fixed options, the following is considered:

• The difference in expected carrying cost (interest cost) during the term

• Risk of early termination

• Risk of unexpected increases in carrying costs

• Mitigation options within a mortgage product

The future is notoriously difficult to predict so the real question becomes what risks do you need to mitigate and how can you use a mortgage product as part of your mitigation strategy. For example, you may have a priority over maximizing your investment returns because you have a contingency plan if interest rates were to increase dramatically. Or you may have a joint venture partner, leading to less predictability on how long you may be holding an investment, therefore making a long term fixed product riskier in some ways. Certain mortgage features may also be part of your risk mitigation strategy.

The Difference in expected carrying costs during the term.

This is where most people start. They assess their cost of a fixed product vs the cost of the variable option over the same term. They then do some form of sensitivity analysis where they test what happens if, say, interest rates go up by a certain amount. Let’s say you have the choice between a variable 5 year mortgage at 2.00% vs a fixed 5 year mortgage at 3.00%. If you believe interest rates are unlikely to change within 5 years, then a fixed product would cost an additional amount of approximately 1.00% of the mortgage. (This example, ignores the compounding impact of monthly principal repayment) However, if you believe you could see increases of up to 2 full points (ie. with a 5 year target of 4.00%) over 5 years and that it would be fairly steady and regular increases then the variable and fixed products will end up costing a similar amount. If the increases happen faster, then the variable will cost more; if slower then the variable will cost less.

In essence, a fixed product can be thought of as an insurance product. You are paying more for the certainty over the fixed term. Sometimes the difference between the variable and fixed rates is small and therefore the “insurance premium” is cheap. Other times, it may be too expensive relative to other options you may have.

It is noteworthy that in the last 4 decades, variable rates have trended downwards and this is often cited as a reason to choose variable. However, also consider that the Bank of Canada overnight lending rate (normally the baseline for variable rate mortgages) is at the lowest it has been in known history (as of January 2022) and doesn’t really have room to drop further. In addition, as seen by Figure 1, even though the variable rate has been dropping, there are periods of years where it has increased and further there have even been periods where the fixed rate was cheaper than the variable rate.

Figure 1 Historical variable rates since 1935

When considering carrying costs, also remember that you can choose shorter term fixed products (e.g a one year fixed rate mortgage) as an alternative to a variable rate mortgage. Some people for example will choose the lowest cost term.

When doing this analysis, also take into consideration your effective tax rate as this will affect your real after-tax costs / savings.

Risk of Early Termination

Life is unpredictable and there are many reasons why you may need to terminate a mortgage earlier than planned. You need to consider these potential scenarios, the probability of it happening, and whether you have mitigation strategies other than termination.

Why is this important? Because different mortgage products allow you different termination flexibility. It is quite common for variable rate mortgages to offer termination with, say, a penalty of three months interest. For residential fixed products it is common to see the greater of three months interest or the interest rate differential[2] (IRD). The IRD can be very expensive under a number of scenarios (such as falling interest rates) and it is wise to have your financial institution or mortgage broker illustrate this cost. In some fixed products, early termination isn’t even an option, and you may need to consider alternate mitigation strategies such as Assignment, an Agreement for Sale exit[3] or some form of mortgage wrap (all subject to the mortgage contract privileges and restrictions).

Early termination scenarios to consider:

1. Joint Venture (JV) partnership requires a sale: JVs are a common structure among newer investors.
   1. Your JV partner has a sudden need of funds due to life events (e.g. divorce);
   2. Your JV partner dies, and the estate requires a settlement of affairs;
   3. You have irreconcilable differences with your JV partner.
2. You have a black swan event in your own life.
3. Your strategy is to cash out opportunistically instead of refinancing.
4. You have an exit/refinance strategy in a shorter term.

It is worth noting that an alternative to a fixed term variable mortgage can be a short term fixed mortgage that aligns with your exit strategy. For example, you may be renovating with an intent to refinance in two years. In this case a two year fixed term may be more appropriate or even an open mortgage if the period is very short.

Risk of unexpected increases in carrying costs

There are situations where predictability of cash flow is a high priority and can be more important than the preceding considerations. In these cases, if the “insurance premium” (difference between the fixed rate and variable rate) is acceptable then you or your business can enjoy a predictable carrying cost over the term. The term of this fixed product can then be set to match a period of time when you believe your investment will have built up enough equity and cash flow to offset future interest rate risks at renewal. A 5 year fixed product is one of the most common choices to meet this objective but longer terms of 7 or even 10 year terms exist and can even be less restrictive in terms of penalties after the initial five year period.

Situations which may make this risk mitigation a priority:

1. You have insufficient reserves to weather a sudden increase in interest rates
2. You have insufficient cash flow to manage increased interest rates above a certain percentage
3. You need predictable cash flow for your business or even your personal life
4. You are someone who is not tolerant of risk and you want to be able to sleep well at night

A fixed term can make the most sense if predictability is important while the risk of early termination is relatively low. For example, if you have no JV partners, you fully expect to hold the asset indefinitely, but you need predictable cash flow to fund your operations then a fixed product may make the most sense in combination with other mitigation strategies.

Mortgage features:

People often think that the only parameter that matters is the interest rate. While it is certainly a key consideration, other mortgage features may give you alternative mitigation strategies to address your requirements.

The following is a sample of common features that you may wish to examine:

• Pay monthly as if it was a fixed rate mortgage
  • This is a common strategy where the borrower uses a variable rate mortgage but pays a larger monthly amount to force the budgeting of the monthly mortgage expense. If rates increase, then the monthly amount will not increase until interest rates go above a certain threshold. In the meantime, you will be making more aggressive principal repayments further reducing your long-term carrying costs.
  • If the mortgage product is combined with say a readvanceable mortgage / Home Equity Line of Credit (HELOC) then this can be a good strategy as you can then access the repaid principal through the HELOC without the need to refinance. See also The Smith Maneuver [4].
  • If you cannot combine it with a readvanceable product then it can be a negative in that it reduces your monthly cash flow and the repaid principal is “trapped” until you can refinance, add a second mortgage, or sell the asset.
• Assignment of the mortgage (aka Assumable Mortgage)
  • If you need to sell the underlying property, then the lender may allow you to assign the current mortgage to the buyer so long as they otherwise meet the lender’s qualifications. This can serve as an early termination mitigation plan. However, keep in mind that the buyer may not be interested in that mortgage if it does not meet their needs (e.g. interest rate or loan amount).
• Portability
  • If you sell a property while purchasing another property, then you may be able to port or move the mortgage to the new property. Usually, the lender is interested in protecting their security so portability can be a method to do that.
• Blending (aka Expandable Mortgages)
  • In conjunction with other features such as portability, assignment or even an early refinance, you may be able to obtain an increase in the mortgage amount before the term is complete. In such a case, the lender may create a new mortgage vehicle which combines the rate of the old mortgage with that of the additional funds obtained.
• Deferrable Payments (aka repayment holiday)
  • If something affects your investment business and you need to defer your monthly mortgage payments, then having the option to defer payments can be valuable. Usually what is done is to take the interest owed and capitalize it (add it on top of the remaining principal) on your current mortgage. This will usually extend the amortization period and you will be paying interest on that deferral. But it can serve as a valuable mitigation plan as we saw during the uncertainty of the initial period of the COVID-19 pandemic.
  • While some institutions may be willing to do this without an explicit written agreement, it is not guaranteed, and it could affect your ability to obtain a mortgage in the future. An explicit contractual option is preferred.
• Convertible Mortgage
  • This type of mortgage allows a borrower to start with a variable rate mortgage but have the option to fix the rate at any time.
  • This can be useful primarily to address changing circumstances in your operations.
  • It is less useful when trying to anticipate future rate increases. The problem is that many borrowers think they will lock in if they see rates going up. But what they forget is that the fixed rates are also moving and if variable rates do go up then the fixed rates will almost certainly be more expensive. This often leads to consternation when it is time to decide as it will feel like you are chasing a runaway train.

Conclusions

Deciding what is best for you and your investment business involves evaluating and mitigating the most important risks in your circumstances. Only you, in consultation with a licensed mortgage professional, can make that decision. I recommend that you identify your risks as you see them and work with a mortgage professional to find a best fit mortgage product.

A final thing to consider is that, as your portfolio grows, you may want to consider a percentage of your assets to be in one form of mortgage product (e.g. fixed) while the remaining may be in a variable rate product. Essentially benefiting from the best of both worlds. For small portfolios, some lenders do offer the ability to mix multiple mortgage types within the same property. That is, you may be able to have a portion of your mortgage at a fixed rate while the remaining amount will be variable.

Balancing your risks is an important strategy in any business and with real estate investments, managing mortgage risks is paramount.

Resources:

[1] Government of Canada overview of mortgages: https://www.canada.ca/en/financial-consumer-agency/services/mortgages/choose-mortgage.html

[2] Definition of “Interest Rate Differential”: https://www.investopedia.com/terms/i/interest-rate-differential.asp#:~:text=What%20Is%20an%20Interest%20Rate,when%20pricing%20forward%20exchange%20rates. 

[3] Agreement for Sale explained: https://barrymcguire.ca/2016/03/30/agreements-for-sale/

[4] The Smith Maneuver : https://www.investopedia.com/terms/s/smith-maneuver.asp

And also: https://smithmanoeuvre.com/what-is-the-smith-manoeuvre/

This article was written in consultation with John Walsh of Canadian Mortgages Inc.