Fixed vs variable mortgage: how each works and how to choose

In Canada, a fixed-rate mortgage keeps the same interest rate for the whole term, so your payment does not change. A variable-rate mortgage usually moves with the lender's prime rate, so your interest cost, and sometimes your payment, can go up or down. Fixed and variable mortgages also differ in how interest compounds and in what it costs to break the mortgage early, which is often the bigger difference in practice. The choice usually comes down to how much payment change you can absorb and how likely you are to break the mortgage before the term ends.

How a fixed-rate mortgage works

With a fixed rate, the interest rate is set when you sign. The fixed rate stays the same until the end of the term, the length of your contract with the lender. Your regular payment stays the same too, and you know exactly how much of the balance you will have paid off by the end of the term.

The trade-off with a fixed rate is that you do not benefit if rates fall during your term. Breaking a fixed mortgage early can also cost a lot, as explained below.

How a variable-rate mortgage works

A variable rate is usually set as the lender's prime rate plus or minus a fixed amount, for example "prime minus a set discount." When the lender's prime rate changes, your rate changes with it.

Variable mortgages come in two main styles:

• Adjustable payment: your payment goes up or down whenever the rate changes, so the payoff schedule stays on track.
• Fixed payment: your payment stays the same, and the split between interest and principal shifts instead. When rates rise, more of each payment goes to interest and less to paying down the balance.

Ask which style a lender offers, because the two styles behave differently when rates move.

Compounding makes a small but real difference

Compounding is how often interest is added to the balance so that interest is then charged on it. Canadian fixed-rate mortgages generally compound semi-annually, meaning twice a year. Variable-rate mortgages often compound monthly.

At the same quoted rate, more frequent compounding costs slightly more. At an illustrative 5% rate (not a quote), semi-annual compounding works out to an effective annual rate of about 5.06%. Monthly compounding works out to about 5.12%. The gap between the two effective rates is small, but it matters when you compare a fixed and a variable rate that look close.

What breaking a fixed or variable mortgage early costs

If you sell, refinance or move your mortgage before the term ends, you usually pay a prepayment penalty. The prepayment penalty is where fixed and variable mortgages differ most:

• Variable: usually three months' interest.
• Fixed: usually the greater of three months' interest or the interest rate differential (IRD).

The IRD compares your rate with a rate the lender uses for the time left on your term. The IRD charges you roughly the difference on your balance for that time. Each lender calculates the IRD in its own way, and the method is set out in your mortgage contract.

At the end of the term there is no penalty to switch lenders. Switching at the end of the term can still carry discharge, legal or registration fees, which the new lender sometimes covers.

An illustration of three months' interest against the IRD

These figures use illustrative rates only; they are not quotes and not how any particular lender calculates.

Say you have a $400,000 balance at an illustrative 5%, with two years left on the term.

• Three months' interest is about $400,000 × 5% × 3/12 = $5,000.
• If the lender's comparison rate for a two-year term were 4%, a simplified IRD would be 1% × $400,000 × 2 years = $8,000.

On a fixed mortgage you would pay the greater amount, $8,000. On a variable mortgage you would usually pay about $5,000. When rates have fallen since you signed, the IRD on a fixed mortgage can be much larger than three months' interest.

How to choose between fixed and variable

Nobody can tell you where rates are headed, and this article does not try. A more useful approach is to ask which risks you can live with:

1. How much payment change can your budget absorb? If a higher payment would cause real strain, the certainty of a fixed rate may be worth more to you.
2. How likely are you to break the mortgage? If you might sell, move or refinance before the term ends, the size of the penalty matters a great deal. Variable penalties are usually smaller and easier to predict.
3. How do you feel about uncertainty? Some people sleep better knowing their payment. Other people are comfortable with movement in exchange for flexibility.
4. How long a term suits your plans? A shorter term can reduce the time you are locked in, whichever type you choose.
5. What do the other features look like? Prepayment privileges, portability (moving the mortgage to a new home) and the option to convert a variable to a fixed rate can matter as much as the rate itself.

The stress test applies to both fixed and variable mortgages. You qualify at the greater of your contract rate plus 2 percentage points, or 5.25%, whichever type you pick. See the mortgage stress test explained.

For more on how mortgages and penalties work, the Financial Consumer Agency of Canada has plain-language guides.

What to do next

If you're weighing fixed against variable for a purchase, renewal or refinance, use our call-me-back form. We'll go through the features and penalties of the options available to you. You can compare payments with the mortgage payment calculator. All mortgages are subject to lender approval.