Fixed vs. variable mortgage: Which should I choose?
When buying a home, the cost of the property isn’t the only factor that affects your monthly payments. If you’re taking out a mortgage, then the interest rate for the loan also makes a big impact. And depending on the type of mortgage you take out, you could end up paying very different amounts in total interest.
In particular, homeowners often decide between fixed-rate and variable-rate mortgages. The same type of decision can apply when taking out a home equity loan, such as if you want to access money for retirement or money for an investment without having to move.
With fixed-rate mortgages, you can gain clarity on how much interest you’ll pay, but that certainty might come at the expense of higher rates. With variable-rate mortgages, you might start off with lower interest rates, and then depending on how the interest rate environment changes, your mortgage rates can change too. In some cases that saves homeowners money compared to a fixed-rate mortgage, but in other cases it can lead to higher interest payments while having less certainty over your monthly payments.
So, which type of mortgage or home equity loan should you choose? There’s not necessarily one right answer, but in this article, we’ll take a deep dive into fixed- vs. variable-rate mortgages to help you make a more informed decision. Given the complexity of taking on mortgage debt or a home equity loan and having a lien on your property, you may also want to consult with a professional and review other sources.
What’s the difference between a fixed vs. variable mortgage?
The key differentiator between a fixed-rate and variable-rate mortgage is how these loans treat interest rates. Not only are the initial rates often different, but with a variable mortgage, the interest rate can fluctuate over time. In contrast, the interest rates for fixed-rate mortgages do not change during the course of the loan.
How does a fixed-rate mortgage work?
A fixed-rate mortgage has a set interest rate for the life of the loan. Whatever rate you initially lock-in, that’s what you’ll pay in the years to come, as long as that same loan remains in effect.
For example, if you locked in, say, a 4% interest rate on a 30-year fixed loan in 2022, then you would still pay a 4% interest rate in 2032, 2042 and every other year all the way through 2052. That fixed rate can give homeowners some stability, as their monthly mortgage payments can stay the same, even if other interest rates change. Keep in mind that a longer-term loan like a 30-year fixed mortgage generally has higher interest rates but lower monthly payments, compared with, say, a 15-year fixed mortgage.
While these long mortgages are fairly common in the U.S., fixed-rate mortgages typically work differently in Canada. In Canada, a five-year fixed-rate mortgage is often used, but that tends to include a 25-year amortization period, meaning the loan gets paid off over the longer period, rather than the five-year fixed term. So, after those first five years are up, the borrower would renegotiate a new fixed-rate term, meaning interest rates might be different at that time.
“A mortgage term is the length of your current contract, at the end of which you'll need to renew; The amortization period is the total life of your mortgage,” explains Ratehub.
How does a variable-rate mortgage work?
A variable-rate mortgage, also known as an adjustable rate mortgage (ARM), can have varying interest rates over the course of the loan period. A common type of variable-rate mortgage, for example, is a 5/1 ARM, where the interest rate is set for the first five years and then adjusts once per year.
“With an adjustable-rate mortgage, the interest rate is fixed for a set period — from six months to 10 years — and then fluctuates up or down for the life of the loan,” explains Freddie Mac (the U.S. Federal Home Loan Mortgage Corporation).
So, an ARM might start at 3%, then go up to 4% a few years later, then 5%, and perhaps end up back at 3%, depending on how market conditions change. Generally, variable-rate mortgages have lower initial rates than fixed-rate mortgages, but the way the market moves can determine if over the long term a fixed-rate or variable-rate mortgage ends up being less expensive for borrowers.
Much also depends on the terms from a variable-rate lender. As the U.S. Consumer Financial Protection Bureau (CFPB) points out, some of the variable characteristics of ARMs include:
- Initial rates and payments: Lenders might offer initial terms that differ from what will occur later on during the course of the loan.
- Adjustment periods: The interest rates for variable-rate mortgages don’t always change at the same rate. Loans can have different adjustment periods. A one-year adjustment period, for example, means the interest rate can change once per year.
- Benchmarks/margin: In setting interest rates, different lenders might follow different benchmarks, such as the Cost of Funds Index, which is based on interest rates for U.S. Treasury securities. From there, lenders add their own margin.
- Caps: ARMs also often have certain caps on how much interest they can charge or how much total payments can be. That can help protect borrowers from astronomical interest rates.
How might rate hikes affect fixed- vs. variable-rate mortgages?
With the Federal Reserve recently starting to raise the federal funds rate in the U.S. to fight inflation, and with the Bank of Canada following a similar course for rate hikes, you may be wondering how higher interest rates affect fixed vs. variable mortgages.
In general, as central banks raise interest rates, mortgage rates increase too. However, there’s not necessarily a direct, one-for-one change, as central banks in North America aren’t setting mortgage rates. Their policies, however, generally influence what lenders such as banks are able to offer borrowers.
If you already have a fixed-rate mortgage, then rate hikes wouldn’t necessarily affect your mortgage. Since the rate is fixed, even if the same lender starts offering higher mortgage rates to new borrowers, the interest rate on your current mortgage debt wouldn’t change. Yet if you wanted to refinance or take a home equity loan, for example, then central bank rate hikes could mean borrowing at higher interest rates.
For those with variable-rate mortgages, then rate hikes can directly lead to higher interest rates on your current mortgage. The next time the lender is able to make an adjustment, they might set a higher rate than what you’re currently paying.
So, that’s a risk to keep in mind with variable-rate mortgages. If central banks decrease rates, then your mortgage rate could also decrease. But as they increase, which seems likely to occur in 2022, then variable rates can go up.
But a rate hike doesn’t automatically mean that you’re worse off with a variable-rate mortgage.
An analysis we ran at Fraction of average fixed vs. variable-rate mortgages in Canada shows that from 2006-2016, on a forward-looking, five-year rolling basis, borrowers would have been better off choosing variable-rate mortgages in every period. During that period, there were both rate hikes and rate cuts by the Bank of Canada, as WOWA.ca shows, though on the whole, interest rates were lower in 2016 than in 2006.
Full disclosure, Fraction offers variable-rate mortgages, but we invite you to explore the data and discuss what might work for your personal finances.
How might a recession affect fixed- vs. variable-rate mortgages?
Many people are also worried about whether an economic recession will occur in the near future, which could also influence the debate between fixed and variable-rate mortgages.
In general, recessions or economic slowdowns cause central banks to cut rates, such as to stimulate spending and lending. That then typically causes mortgage rates to fall, but it’s not always so direct and can take time to play out. For example, look what happened around the 2007-2009 Great Recession:
- In 2006, the average 30-year fixed-rate mortgage in the U.S. was 6.41%, according to Freddie Mac. Meanwhile, the Federal Reserve set the federal funds rate as high as 5.25% that year.
- In 2008, the Fed aggressively cut rates, reaching a level of 0-0.25% by the end of that year. For 2008, the 30-year fixed-rate mortgage average fell to 6.03% (down from 6.41% in 2006), and then reached 5.04% in 2009.
- In the years following, with the economy still arguably struggling and the Fed holding rates near zero, 30-year fixed-rate mortgages tumbled to an average of 3.66% in 2012.
So, if you had a variable-rate mortgage around this period, it’s possible that your rates fell. In contrast, starting a fixed-rate mortgage before the recession would have meant that you paid the same rates the whole time, even as market rates fell, unless you took steps like refinancing.
That said, a recession doesn’t automatically mean that those with variable-rate mortgages will be able to take advantage of lower interest rates. It’s possible for the economy to falter while interest rates rise, which is what happened in the early 1980s.
“Between 1980 and 1982 the U.S. economy experienced a deep recession, the primary cause of which was the disinflationary monetary policy adopted by the Federal Reserve,” notes research from the University of California, Berkeley.
During that period, as the Fed tried to fight inflation, interest rates were extremely high. The average 30-year fixed-rate mortgage went as high as 18.45% in October 1981.
So, you shouldn’t assume that a recession would lead to lower interest rates. A cap on variable-rate mortgages could at least help homeowners avoid paying exorbitant rates, but it could still involve an increase during a recession.
Are fixed- or variable-rate mortgages more appealing now?
Choosing between a fixed- or variable-rate mortgage right now depends on several factors, such as whether you think rates will continue to rise. Keep in mind that it can be tough to predict what will happen. During the early days of the COVID-19 pandemic, for example, central banks quickly cut rates. That said, the Bank of Canada and Federal Reserve do appear headed toward more rate hikes in the near term, unless something else unexpected occurs.
You also might want to consider your risk tolerance. Some homeowners might prefer the stability of a fixed rate, whereas others might prefer to take a chance on variable-rate mortgages, hoping that over the course of the loan they end up paying less interest.
Also consider how long you plan to live in your current home. For example, if you plan to sell within five years, then a lower initial rate from a variable mortgage might make sense, as Freddie Mac notes.
If you’re looking to tap into your home equity, such as to access money for retirement, money for an investment, or to consolidate debt, then you also might want to weigh whether a fixed- or variable-rate home equity loan makes sense for your needs. It’s possible that choosing a variable-rate home equity loan, for example, might hedge against choosing a fixed-rate mortgage if you use your equity to buy an investment property.
The Fraction Mortgage offers a variable-rate loan in five or ten year terms that can be refinanced as much as needed. Unlike a traditional HELOC that requires you to pay a minimum balance, the Fraction Mortgage provides the loan as a lump sum, with no monthly payments required.* So, that could potentially help homeowners ride out any negative effects stemming from interest rate hikes and/or recessions.
With Fraction, you can unlock up to $1.5M of your home’s equity to use how you see fit.
Get your free estimate today.
Disclaimer: Information in this article is general in nature and not meant to be taken as financial advice, legal advice or any other sort of professional guidance. While information in this article is intended to be accurate at the time of publishing, the complexity and evolving nature of these subjects can mean that information is incorrect or out of date, or it may not apply to your jurisdiction. Please consult with a qualified professional to discuss your specific situation and confirm any information.