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%.)
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