TORONTO, September 9, 2011 - With interest rates hovering near record lows, many Canadians may be considering the purchase of a home. And in the current interest rate environment, now more than ever home buyers are grappling with the age-old question of whether to choose a fixed or variable rate mortgage.

"With short-term rates now likely to stay at very low levels, and long-term rates testing record lows, whether to lock into a longer-term fixed mortgage rate or choose a variable rate continues to be a hot-button issue among home buyers," says Benjamin Reitzes, Senior Economist, BMO Economics.

Historically, research shows that there is little debate as to which has been the better option for homebuyers. Typically, borrowers save money by staying in variable products, and riding the rollercoaster of fluctuating rates. In fact, since 1975 the cost-effective route for borrowers was to stay variable 83 per cent of the time. And while the spread between 5-year fixed mortgage rates and variable rates has fallen from the all-time high hit in mid-2010, it remains historically elevated.

But before declaring a hands-down winner, Mr. Reitzes points out that there are a number of important points to consider:

•  We have been in a long-term declining rate environment, almost without a break, since the early 1980s.
•   The Bank of Canada's policy rate is extremely low, so there's limited further downside for variable rates.
•   Fixed rates were advantageous during only two recent periods-through the late 1970s and briefly in the late 1980s; in both cases, ahead of a period of rising interest rates, which is likely the case in 2012 and beyond.

The Case for Staying Fixed

A fixed rate mortgage can mitigate a number of risks. While inflation hasn't been a big issue in Canada, averaging 2 per cent since 1991, there is the risk of a flare-up at some point down the road. This could force the Bank of Canada to raise interest rates aggressively, increasing variable mortgage rates but leaving fixed rates unscathed. Fixed rates are also attractive in the current environment as short-term rates are already extremely low. Considering the likely upward trend in interest rates (similar to the late 1970s and 1980s), this may be a period when a fixed rate turns out to be the superior choice. Finally, it provides certainty, and that certainty is worth something to many.

The Case for Going Variable 

The advantage to a variable rate mortgage is that it has been less costly than its fixed rate counterpart over time, with only a few of occasions where a variable rate was less favourable. Furthermore, tame inflation, along with an uncertain global economic outlook and the Federal Reserve holding U.S. rates near-zero through 2013, point to the Bank keeping rates steady well into 2012. There is also risk to locking in, as fixed rates could fall if the economy underperforms. And lastly, even as rates finally start to rise, buyers and homeowners can always lock into a fixed rate at a later date.

The Verdict: The decision really does depend on the individual. For first time home buyers or those without financial flexibility that would run into difficulty from a pronounced upswing in interest rates, the small extra cost for peace of mind may be a price worth paying. Our interest rate outlook projects a modest benefit to choosing a fixed rate. However, given the historical advantage of going variable, and the many downside risks plaguing the global economic landscape, the variable rate option remains extremely attractive-but it's a much closer call than usual.

Katie Archdekin, Head of Mortgage Products, BMO Bank of Montreal, suggests that regardless of whether home buyers choose a fixed or variable rate, they should stress-test their mortgage in advance to make sure any potential increase in interest rates are manageable. "While low interest rates can provide opportunities for home buyers, it's best that Canadians think long term when planning to buy a home," said Ms. Archdekin.

She adds that based on the average household income in Canada, a typical new home buyer uses just over one-third of their average household disposable income to service their housing costs today, in line with historical norms.