Mortgage terms: fixed vs. variable

Despite the proliferation of information regarding mortgages, there’s still a lot of confusion about what’s the best deal. Today we’ll examine whether or not a fixed or a variable rate mortgage is right for you.

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Part 2: Variable Vs. Fixed

When choosing the best mortgage you’ll need to decide between a variable or fixed rate mortgage—terms that are not synonymous with open and closed.

Open/closed mortgages refer to the flexibility you have in paying off the mortgage debt, while fixed/variable mortgages refers to how the interest rate is calculated and applied.  (That means you can have: a fixed closed mortgage, a variable closed mortgage, a fixed open mortgage, and a variable open mortgage.)

The key to variable and fixed rates is to understand how interest rates are calculated and how these impact each type of mortgage:

  • Fixed rates are based on movement in the bond market (the benchmark for a 30-year fixed rate mortgage is the yield of a 10-year bond). As bond prices rise, fixed rates will also rise and the spread between the two reflects the risk investors are willing to take when they move their money from a secure product, like bonds, to invest in mortgage securities. There are times when that spread becomes very wide or very thin—a reflection of world events, such as the subprime mortgage crisis of 2008/2009 and the recent catastrophic situation that has befallen Japan.
  • Variable rates, on the other hand, are priced in accordance with changes to money market conditions. That means if the prime rate goes up — based on changes made to the Bank of Canada’s overnight rate — then variable rates will go up. While these changes are more volatile, they don’t typically occur more than once per month. That means the interest rate on your mortgage could change from month to month, however your monthly payments will stay the same (but the amount applied towards the principal will change as the rate changes).

Given the historically low interest rates you may be tempted to simply select the cheapest mortgage option, typically a closed variable, and be done with it. (As of March 15, closed variable had a posted rate of 2.4%, compared to the 5 – year fixed posted rate of 3.9%.)

Best Option

But is this the best option?

Not according to a number of financial experts, including Robert Abboud, an Ottawa – based CFP and the author of No Regrets: A common sense guide to achieving and affording your life goals, our very own Canadian Capitalist blogger, Ram Balakrishnan, and Dr. Moshe Milevsky, the York university professor whose initial 2001 study became the impetus behind the current belief that you’ll always save with a variable rate mortgage.

According to Milevsky’s 2001 study (and the updated study released in 2008), homeowners who opt for a variable rate mortgage save approximately $22,000 in interest payments over a 15 – year period. But context is everything. The study, and its update, examined mortgages between 1950 and 2007. And since the study was published the spread (otherwise known as the difference between variable and fixed rates) has thinned out. Also rates, which were consistently falling over the last 25 years, have since bottomed out. Now they have nowhere else to go but up. Add to this the historical response by governments to tough economic times: stimulate spending, which generates inflation. To combat this inflation, governments raise interest rates — sometimes suddenly and ruthlessly — and this has an immediate impact on variable rates (and the overall economic condition eventually impacts fixed rates).

For that reason, Milevsky, and others, have voiced their support for locking – in to a fixed rate. The rationale: any savings you see from currently low variable rates will be eaten up when you’re forced to renegotiate your mortgage in five years. That’s because as rates slowly creep up over the next five years, your monthly payments remain the same — and this results in a larger percentage of your payment going to interest payments, rather than repaying the principal.

So, to decide whether a variable or fixed mortgage is better for you, answer these questions:

1)            Do you currently have a big mortgage?

2)            Do you expect to have a big mortgage in five years?

3)            Would it be virtually impossible to make additional monthly or lump – sum payments against the mortgage?

4)            Would it be a burden to find an extra $100 or $200 per month for mortgage payments?

5)            Does the thought of uncertain rates and fluctuating payment amounts keep you up night?

If you answered yes to any of these questions, seriously consider a fixed – rate mortgage.

Despite the temptation of saving money with a variable rate mortgage, a fixed rate will provide a level of stability and predictability that your situation requires. And this is particularly true for people who have big mortgages AND cannot commit to additional monthly or annual lump – sum payments. That’s because the lower – sum payments you get with a variable rate mortgage means you make less of a dent in your principal as interest rates rise.

Take, for instance, a $350,000 mortgage. If you selected a variable rate mortgage, at 2.4%, and that rate stayed stable for five years you’d end up with a mortgage balance of $295,706. Compare this to a mortgage balance of $303,780 with the 3.8% fixed rate. But if interest rates start to climb—and you know they will—then those savings will be eaten away. For example, if rates rise by a quarter of a percent every six months, you’d end up with a mortgage balance of $302,209.

Tomorrow: Further options

49 comments on “Mortgage terms: fixed vs. variable

  1. Interesting take but I think I’ll be sticking with the studies that Ive read which have tracked both over 2-30 yrs and still showed variable to be cheaper. Most of those we know who variable did so prudently by making sure if the rate went up during the assumed time they would own the house/ condo they could still afford the payment. I agree it’s another case of do your homework and what works best for you. For me Im not not willing to pay the (probable) premium for (possible) peace of mind.

    Im curious if in the last paragraph about the variable rate going up and therefore start to erode savings, would the fixed rate not go up as well therefore preserving some of the savings? It’s not clear if the final conclusion made is based on the fixed rate rising as well.

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  2. FYI…my sentence I was refering to studies which have trackd and compared both types of rates over a 20-30 yr span.

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  3. Well if the spread gets narrower then I will be seriously considering a fixed next time.

    For now though I am in variable and not locking in… yet.

    I have been very prudent however – prime less 75 points ( 2.25 %) on the variable for the mortgage, but I set the payments as if the effective rate was 5% (roughly the fixed at the time a couple of years ago). That means while rates stay low I am paying down principal much more quickly, and rates have to go up dramatically to force a payment increase.

    The bottom line is that rates have to really spike to make a fixed a better deal financially if you set your payments at where they would be if you went fixed. Rates have to go up enough to cover the spread and do it early enough that the higher rates can eat away at what I save while the variable rates are lower.

    I can answer no to all of those questions – but from a purely financial point of view I still don’t see a fixed rate as a better deal. Even if I lose on a fixed over one 5 year period if there is a big spike, I will still be ahead over the term of the mortgage by sticking to variable. To try and switch to fixed and back to variable I would have to be better at predicting interest rates than the economists at the banks and the Bank of Canada. I don’t think I’m that good!

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    • Agreed. We are in the process of doing research for a new home and while looking at varible rates did just as you did and calculated if we could afford payments at a fixed rate for same time period for peace of mind minus the built in premium. Im not sure if most people understand the very high percentage of interest you pay in the first 5 yrs and how much a lower rate of interest plus extra pyts (as you did) really pays off.

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  4. Absolutely! Sean (and Marie), the fact that you are taking advantage of the lower rate BUT paying the monthly fee as if you were with a higher rate fixed mortgage is ideal, since you're paying off more of the principal with each payment. Then, when you do finally go to lock-in, you'll be renegotiating for a much lower mortgage principal. Brilliant!

    Unfortunately, not everyone is as disciplined or as wise–and if a person ends up taking a variable rate and doesn't take advantage of higher prepayment options, they can get a rather nasty shock when rates start to climb and they either try to lock-in, or go to renegotiate.

    Thanks for reading the piece, answering the questions, and making some valid objections. I think I'll do a bit of math to see how rising interest rates over a long-term horizon are impacted by current decisions. It would be interesting to see if a climb in interest rates really does allow variable rate mortgage-holders to save money in the long-run–considering all past studies concentrated on historical data that showed consistently declining interest rates over a 25-year period.

    @Marie: Good point on savings erosion from climbing rates. Because the fixed rate is tied to a specific term, say five years, you wouldn't need to worry about rising rates during that term as your payments would remain the same. In other words, if interest rates started to rise 0.25% every 6 months, but you locked in at 3.85% for five years, then the variable rate mortgage would be impacted by this increase, but not the person already locked-in to the fixed rate mortgage. Hope that helps!

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  5. Hi Romana,

    With the spread so low, it certainly bears examination. An important question is, will the spread remain this low as rates rise? The banks depend on a decent yield curve, and the long bonds have been getting killed lately – a trend I don’t see stopping any time soon.

    My current variable is 2.25% – let’s call a 5 year fixed 3.75% for simplicity – so a 1.50% spread. It would take a big inflation spike for them to jack rates fast enough to cause me a problem. Using your example of 25 points every 6 months it would take 3 years for the spread to equalize and you’d only have 2 years of the same raises – so variable would still win in terms of interest over the 5 year term. The higher rates in the last 2 years would not erase the gains in the first 3 years. We’d need some sort of black-swan inflation spike where they had to jack it several full % points in a short period of time to wipe out the gains. That could of course happen – but I think the probability is on the side of the variable.

    Even if the worst case happens and rates spike on the short end of the maturity curve, you have to get lucky and have it happen at just the right time – right after you lock in for 5 years. When rates rise, the long bonds will get killed and fixed rates will rise right along with them. You might win over a 5 year if you are lucky with the timing, but over 25 years it’s much more probable that going variable the entire time is the best deal.

    Reply

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