Fixed vs. variable rates: A cash flow analysis during an energy crisis

If you have a loan coming up for renewal, and/or are looking at taking out a new loan, you may be wondering how the war in Iran is changing the cost of borrowing – and whether a fixed rate or variable rate term might be best for your operation.

There are many different factors to consider when choosing between a fixed and variable rate. This includes, but is not limited to, the timing of capital investments (loans being paid off, when new investments will be required); product features, including prepayment limits and fees; cash flow and structure of existing debt, including existing floating debt exposure; and one’s own risk tolerance.

In this article, we’ll look differences between different types and lengths of terms from a purely cash flow perspective. While we will use scenario analysis to get a deeper understanding of the differences between these products, we won’t get into interest rate projections themselves – we’ll have more to say on that when our Economic and Financial Market Update is released next month.

5-year fixed rate terms have recently fallen out of favour with Canadians

Our past analysis on this topic explored the differences between just two terms: variable rates and 5-year fixed rates. However, if you want to borrow fixed, you do not necessarily have to lock-in for five years as many fixed-rate terms are shorter.

In fact, the popularity of 5-year fixed rates has fallen recently. Last year, only 13% of residential mortgages were 5-year or longer fixed rate terms, where between 2013 and 2020 they were about one-third of all mortgages on average (Figure 1). At the same time, there has been a surge in the popularity of fixed terms from 3 to less than 5 years (i.e., 3- or 4-year terms). Indeed, terms of this length were the most popular type of term between 2023 to 2025, including accounting for nearly half (49%) of all mortgages in 2024.

Figure 1: 3- and 4-year fixed rate mortgages have been the most popular in the last three years

Sources: Statistics Canada, FCC Economics

This led us to the question: with the power of hindsight, which borrowing strategy would have cash flowed best?

To answer that question, we create three hypothetical terms:

• A 5-year variable rate

• A 5-year fixed rate

• A ‘mix’ strategy that involves a 2-year fixed rate first and followed by a 3-year fixed rate

To complete the analysis, we need to make some assumptions common to all three loans:

• The mortgage amount is $500,000

• Amortization is 25 years

• Payments are monthly

• All are closed

• We do not make assumptions about the individual borrower’s creditworthiness

More to the last bullet point, we need to make some assumptions about average spreads – that is, the difference between the borrowing rate (which reflects things like a borrower’s creditworthiness, security strength, the financial institution’s margin, etc.) and what we’ll call the foundational rate, that is, the overnight rate and/or the bond rate. For more on foundational rates and how they ultimately impact borrowing rates, see here.

Making assumptions about average spreads can be challenging given every individual’s situation is unique. However, using the same Statistics Canada data from Figure 1, we set some average spread by term type and now turn our attention to analyzing cash flow.

Variable rates terms underperformed other strategies since 2013

After completing the analysis, it’s quite clear that going variable at the beginning of the century would have been cash flow favourable (Table 1). This is a function of the BoC cutting the overnight rate more often than not during this time. Since 2013, though, it would have been beneficial to either enter a 5-year fixed rate term or go with the ‘mix’ strategy.

Let’s pick one year to illustrate. Rewind to May 1, 2019: the overnight rate was 1.75%, and bond yields were relatively low by historical stands, with the 2-year at 1.57% and the 5-year at 1.55%. Locking in a 5-year fixed rate at that time would have been appealing and resulted in total payments for the next five years of $143,700. Going variable would have resulted in significant savings early in the term, given the BoC cut rates to near zero in March 2020; but, as we know, the central bank began raising rates in 2022, thus offsetting the earlier savings. Total payments on a variable term would have been $158,500. Using the ‘mix’ strategy in 2019 would have resulted in the lowest cash outlays. The 2-year bond yield at origination was low (1.57%) but at renewal in May 2021 bond yields were even lower (0.48% on a 3-year bond). Locking that in for the remainder of the period resulted in the best outcome.

We did this analysis for each year between 2000 to 2021 with the results below in Table 1.

Table 1: Total payments of different term structures and strategies

Rounded to the nearest $100. Products with the lowest total payments by year are highlighted in grey.

Sources: Statistics Canada, FCC Economics

To be clear, in this analysis, we are only looking at total payments over the five-year period in question. We do not analyze interest / principal splits nor ending balances.

What about looking forward?

While the above example suggests going variable may have been the poorest performing strategy since 2013, that’s not to say it will be so for future time periods as well.

There’s plenty we don’t know for sure, most importantly the path of the overnight rate set by the BoC for the next five years. But we do know as of mid-May what 2-year and 5-year bond yields are. And if we make some assumptions about the future overnight rates, we can calculate cash flows under different interest rate scenarios.

Let’s focus on one type of term at a time, starting with 5-year fixed rates. Given bond yields as of early May, if you go 5-year fixed you’d pay $170,500 over the life of the term.

Next up is variable rates. If the BoC held the overnight rate flat for the next five years you’d be looking at total payments of $160,300. The odds of that occurring, however, are extremely low. What might cause the overnight rate to move up or down? Here, we can turn to Moody’s for some guidance:

1. Upside scenario (rate hike): geopolitical pressures and trade relationships both gradually improve, and the economy grows faster than currently anticipated.

2. Downside scenario (rate cut): global tariffs are broader and in place longer, the recent energy shock persists, and the global economy teeters, and Canada enters a recession.

Under this upside scenario where the BoC raises the overnight rate you’d be looking at another $6,700 in payments relative to the ‘hold’ scenario (Figure 2). Conversely, under the downside scenario where the BoC cuts rates, you could be looking at savings of $14,600, relative to the scenario where they hold rates flat.

Extreme caution needs be used here: these scenarios are scenario-derived overnight rate paths that we used here for illustration purposes only. The timing and size of changes in the overnight rate are, of course, unknown. Regardless, future movements in the overnight rate – up or down – will change payment amounts on a variable rate loan.

Figure 2: BoC overnight rate paths, total payments on variable rate terms under different scenarios

Rounded to the nearest $100.

Sources: Moody’s Analytics, Statistics Canada, FCC Economics

The question on most economists’ minds right now is how will the BoC respond to the situation in the Middle East? For their part, the BoC said in April it “will not let higher energy prices become persistent inflation”, indicating rates may need to rise if the conflict continues and energy prices remain elevated. At the same time, they stated “If the United States imposes significant new trade restrictions on Canada, we may need to cut the policy rate further to support economic growth.” This refusal to commit on interest rates reflects the enhanced uncertainties the Canadian economy is facing on the trade front, but also on inflation as a result of the war in Iran.

Finally, let’s say you’re wanting to utilize the ‘mix’ strategy of going with a fixed rate but for shorter periods. We know the 2-year fixed today but do not know what the 3-year bond yield will be at renewal in 2028. If you assume it stays the same as it is today, you pay $170,700 over the five years. Your total payments will move up or down if the 3-year bond yield at renewal is higher or lower (Table 2).

Table 2: Bond yields, total payments with a ‘mix’ strategy under different scenarios

In summary, and based on the simulations above:

• A 5-year fixed rate is the only strategy with cash flow certainty ($170,500).

• The ‘mix’ strategy, based on yields today, results in essentially the same cash outlays as the 5-year fixed ($170,700). Only if bond yields are lower in three years at renewal will it result in savings.

• The variable rate strategy cash flows best under our overnight rate path scenarios. However – and this is a big however – scenarios where the BoC has to raise rates more than what is shown in Figure 3 could result in situations where going variable results in higher payments than the 5-year fixed strategy.

Bottom line

Choosing between a fixed and variable interest rate is not about trying to time the market or predicting exactly where rates will go next. The analysis above benefits from hindsight, but the reality is that the future path of interest rates is highly uncertain. Both fixed and variable options come with real advantages and trade-offs, and neither is inherently “right” or “wrong.” Moreover, interest rates are only one piece of a much larger profitability picture. Conducting scenario analysis, as we’ve done here, can help operators better understand how different choices may perform across a range of economic environments, supporting more informed and resilient borrowing decisions.

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Graeme Crosbie

Senior Economist

Graeme is a Senior Economist at FCC. He focuses on macroeconomic analysis and insights, as well as monitoring and analyzing trends within the dairy and poultry sectors. With his expertise and experience in model development, he generates forecasts of the wider agriculture operating environment, helping FCC customers and staff monitor risks and identify opportunities.

Graeme has been at FCC since 2013, spending time in marketing and risk management before joining the economics team in 2021. He holds a master of science in financial economics from Cardiff University and is a CFA charter holder.