How to choose between a fixed and variable interest rate?

Deciding between a fixed and variable mortgage interest rate is one of the most critical financial decisions you will make when buying a home in Calgary. This decision directly affects your monthly payments, the total cost of the loan, and your financial stability throughout the life of the mortgage.

The current market situation in Calgary creates unique conditions where the best 5-year fixed rates are 4.04% and variable rates are 3.95%, making both options competitive.

The choice between these two types of rates depends on your risk tolerance, financial situation, predictions about future interest rates, and personal preferences for budget planning. Each type has its own advantages and disadvantages that should be carefully considered before making a decision.

Fixed interest rates: stability and predictability

How fixed rates work

Fixed interest rates remain the same for the entire term of the mortgage agreement. This means that your monthly payments will be the same regardless of how interest rates change in the economy.

In Calgary, 80% of all mortgage applications through Ratehub.ca in 2023 were for 5-year fixed rates, confirming their popularity among Canadian homebuyers.

Fixed rates are determined by government bond yields, especially 1-, 3- and 5-year bonds. When bond yields rise, fixed mortgage rates rise, and vice versa.

The current yield on 5-year Canadian bonds exceeds 3%, which explains the relatively high rates compared to previous years.

Advantages of fixed rates

  • Budget predictability — you know exactly how much you will pay each month for the entire term. This simplifies personal finance and family budget planning.
  • Protection against rate increases — if the Bank of Canada raises its key rate, your payments will not increase.
  • Ease of understanding — fixed mortgages are convenient for first-time buyers: there is no need to track rate changes and recalculate your budget.

Disadvantages of fixed rates

Higher initial rates have historically been the main disadvantage of fixed mortgages. Fixed rates are typically higher than variable rates at the time of origination, although in the current environment, the difference is minimal. The average difference between the best fixed and variable rates in Calgary is only 0.09%.

Lack of flexibility means that you cannot switch to a variable rate without breaking your contract. If interest rates fall after you take out your mortgage, you will not benefit from these changes until your contract is renewed.

Higher prepayment penalties are a significant disadvantage of fixed mortgages. The penalty is calculated using the interest rate differential (IRD) formula, which is typically thousands of dollars more than the penalties for variable mortgages, which are only three months' interest.

Variable interest rates: flexibility and potential savings

How variable rates work

Variable interest rates are tied to the lender's prime rate, which changes in line with the Bank of Canada's key rate decisions. The current prime rate is 4.95%, and the best variable rates are offered at a discount of Prime - 1.00%, giving an effective rate of 3.95%.

There are two types of variable mortgages:

  • With fixed payments — the monthly payment amount remains the same, but the ratio between the principal and interest changes.

  • With variable payments — the payment amount changes in line with changes in the interest rate.

Advantages of variable rates

  • Historical savings — according to research by Professor Moshe Milevsky of York University, between 1950 and 2000, Canadian homeowners would have benefited from variable mortgages almost 90% of the time.

From 2007 to 2022, 5-year variable rates were mostly lower than fixed rates, sometimes significantly.

  • Lower current rates make variable mortgages attractive in the current situation. The best 5-year variable rate — 3.95% — is lower than the best fixed rate 4.04%, which can provide savings from the outset.

  • Convertibility allows you to switch to a fixed rate at any time without penalty. This provides flexibility to respond to changes in the economic situation or personal circumstances.

  • Lower early repayment penalties are typically only three months' interest, which is significantly less than fixed mortgages. This makes variable mortgages a better option for those who may need to repay early.

Disadvantages of variable rates

Unpredictable payments are the main risk of variable mortgages. If interest rates rise, your payments could increase significantly.

Between March 2022 and July 2023, variable rates rose from 0.85% to over 5%, leading to dramatic increases in payments for many borrowers.

Trigger rate risk and choosing between fixed and variable mortgages in Calgary

Trigger rate risk is a serious issue for fixed-payment mortgages. When interest rates rise so much that payments do not even cover the interest, the mortgage enters negative amortization, where the total debt actually increases. Many borrowers faced this problem in 2022-2023.

Need for active monitoring

Constant attention to interest rate changes can create additional stress and require greater involvement in mortgage management.

Factors influencing the choice

Personal risk tolerance

Your ability to cope with financial uncertainty is a key factor. If you can easily handle payment fluctuations and have a financial safety net, a variable rate may be appropriate. If stability is a priority, a fixed rate will provide peace of mind.

Current financial situation

  • Income level and stability affect your ability to handle variable payments.

  • The size of your mortgage also matters: even a small difference in rates can significantly change your monthly payments. For example, a 0.5% difference on a $500,000 mortgage changes the payment by approximately $125.

Interest rate forecasts

For 2025, most banks are forecasting a gradual decline in rates. The Bank of Canada's key rate is expected to fall to 2.25%–2.75%. This creates an advantage for variable rates, but there are risks due to:

  • trade wars,
  • geopolitical instability,
  • inflationary pressures.

Impact of the mortgage stress test

The federal stress test applies to both fixed and variable mortgages. Borrowers must qualify at the higher of the following two rates: contract rate + 2% or minimum qualifying rate of 5.25%.

  • For a fixed rate of 4.04% → test = 6.04%.
  • For a variable rate of 3.95% → test = 5.95%.

This may allow you to borrow a larger amount with a variable rate.

Calculating the financial impact

On a $500,000 mortgage with 25 years amortization:

  • Fixed rate of 4.04% → slightly higher monthly payments.
  • Variable rate 3.95% → savings of about $25 per month, which can add up to thousands over the life of the mortgage.

But the calculations assume that the variable rate does not change, which is unrealistic.

Scenarios

  • Rate decreases → variable rates are more advantageous.
  • Rate increases → fixed rates provide protection.
  • Stable rates → the current slight advantage of variable rates will remain.

Risk hedging strategies

Hybrid approach

You can split your mortgage into two parts:

  • one at a fixed rate for stability,
  • the other at a variable rate for potential savings.

Short-term fixed rates

1-3 year contracts are often better than 5-year ones, letting you take advantage of current conditions.

Regional characteristics of Calgary

  • Alberta's energy sector makes some families' incomes unstable → fixed rates are safer.

  • Migration trends support housing demand, stabilizing the market.

  • Competition among lenders in Calgary creates favorable conditions for borrowers.

Recommendations for different categories of buyers

  • First-time buyers → better to choose fixed rates for stability.
  • Experienced investors → can take advantage of variable rates for potential earnings.
  • Financially stable families → can choose variable rates, leaving the option to convert to fixed rates.

Practical tips for decision making

  • Consulting with a mortgage broker will help you model all scenarios.
  • Market monitoring is important for proper timing.
  • Creating a financial cushion for 3-6 months of payments minimizes risks.

Conclusion

The choice between a fixed and variable interest rate in Calgary depends on:

  • your financial situation,
  • risk tolerance,
  • market forecasts.

The small difference between the two types of rates makes both options viable, but the right decision can save you thousands of dollars over the life of your mortgage.