Fixed rate vs. variable rate mortgages: Which is better?

First-time homebuyers can become mired in worries over the best mortgage terms, trying in vain to forecast interest rates. Should they go for one year? Five years? What about a variable-rate mortgage?

"There are pros and cons to each of these choices," says David Dobbin, product director of mortgage products with Manulife Bank. "The key is to understand them and make the choice that best suits your individual circumstances."

A fixed-rate mortgage is pretty much what it sounds like: you choose a period of time — such as three years—and the bank guarantees you the posted interest rate for that period. So if you opt for a three-year rate at four per cent interest, then for the next three years the bank will charge you four per cent interest on your mortgage.

In contrast, a variable-rate mortgage comes with no guarantees. Your bank charges you monthly interest at a floating rate that can change at any time depending on where interest rates are headed generally. The rate usually moves in tandem with the bank's prime rate.

Seems like a no-brainer: the fixed-rate mortgage is obviously the way to go, right?

Actually, many financial advisors believe variable-rate mortgages are better. The main advantages of fixed-rate mortgages are peace of mind and stable monthly payments. But a variable-rate mortgage could save you thousands of dollars over time, says Dobbin.

"One study that reviewed 50 years of mortgage rate data concluded that Canadians who locked in at fixed rates paid more than they needed to," Dobbin points out. As the chart below illustrates, over 15 years, on a mortgage of $100,000, the average Canadian could have saved more than $22,000 in interest with a floating rate compared to a fixed rate.

In Mortgage Financing: Floating Your Way to Prosperity, Moshe Milevsky, the York University professor who conducted the study, says nine times out of 10, you would have been better off borrowing at the floating rate than locking in to a five-year rate.

What about those interest rates?
Before you sign on the dotted line for a variable-rate mortgage, you probably want to know more about what could make interest rates rise in the near future.

Interest rates are difficult to predict because so many variables influence their behaviour. Inflation can lead to higher interest rates as governments try to slow economies down. Decreasing demand for credit can lead to lower rates because there are more people lending money than borrowing. Generally, a slowing economy spells lower interest rates while a growing one usually leads to higher rates.

Nonetheless, citing Milevsky's analysis, between 1950 and 2000 there were really no clear indicators as to when was the right time to lock your mortgage in. Today, it appears that more and more Canadians are heeding his advice and simply letting their mortgages "float."

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Fixed-rate vs Variable-rate