To lock in your variable mortgage or stay fixed.
It’s a question many people are debating right now. As a mortgage broker I get asked about this daily.
I am personally buying a home right now, I actually get the keys May 12th! I cannot tell you what the right decision is for yourself but I will share why I am sticking with a variable.
Should I lock in to a fixed rate mortgage?
If I lock into a fixed rate today I will be guaranteeing roughly another 8 increases overnight. This is because fixed rates are roughly 2% higher than variable rates currently. On top of this locking into a fixed rate increases prepayment penalties by almost 800%.
The numbers behind the fixed vs variable debate
Here is some quick math on the average interest rate over 5 years (broken into 8 sections per year as the Bank of Canada increases rates). I have marked the increases in orange.
Click the image for a bigger photo
This scenario assumes 8 further rate increases over 2 years and then rates stabilize. (The average cost/rate over 5 years is in yellow)
See the 8 increase scenario (8 orange boxes) (sorry you have to click the image to see the full picture)
If rates increase beyond the 8 increases in 2 years variable would likely cost more. The risk of this could be reduced by paying down extra principle on your payments.
See the 10 increase scenario (10 orange boxes) (sorry you have to click the image to see the full picture)
These numbers can be altered by changing when rates increase, this is not a prediction but rather an illustration of how increases may alter your average interest rate.
What does this mean to you?
In both these scenarios (8 increases and 10 increases) the variable rate barely costs more than the fixed-rate option. If rates increase more gradually, increase and then retreat or fail to rise this sharply the variable option is the clear winner. You will need to ask yourself if you expect rates to rise beyond these scenarios.
It was this breakdown that led to me deciding to stay variable (after much consideration). I personally believe variable is still the safer route for many Canadian due to the lower prepayment penalties and lower interest costs upfront (prepay your mortgage during this time if you can but do not exceed your prepayment limits). I have also attached the
spreadsheet I used for this math if you want to run your own rate vs your lock-in options.
spreadsheet I used for this math if you want to run your own rate vs your lock-in options.
A final word on fixed vs variable – Unless you are going to pay off your mortgage in the next 5 years a fixed rate only DELAYS your exposure to rising rates. Let’s say you have a mortgage you will pay off over the next 25 years. Imagine rates gradually rise over the next 25 years.
John Fixed and Jane Variable – A tale of two borrowers
I want you to imagine two neighbors, John Fixed and Jane Variable. John and Jane both bought identical houses for the same price on the same day.
John Fixed takes a fixed-rate mortgage at 4.14%
Jane Variable takes a variable rate mortgage at 2.6%.
Let’s assume that rates increase based on our second scenario (10 increases over 5 years).
In the first 5 years, John and Jane have a very similar interest costs.
Jane averages 4.21% and John averages 4.14% (because he had a five-year fixed).
5 years after they bought their home they both renew. John adjusts from
4.15% to market rates of 6.6% (5-year fixed) and Jane adjusts from 5.6%
to a similar variable product.
4.15% to market rates of 6.6% (5-year fixed) and Jane adjusts from 5.6%
to a similar variable product.
And the cycle repeats… every 5 years John Fixed takes a new fixed mortgage and Jane Variable rides the rates up and down. If rates rise gradually John Fixed only delays the change, every 5 years he has drastic swings in his rates. When rates drop from time to time Jane Variable benefits from this.
Meanwhile John Fixed watches with envy, he even goes to his bank asking about refinancing but gives up in frustration when he realizes his penalties are 900% larger than Janes.
When does a five year fixed rate make sense?
The only scenario John Fixed comes out ahead is if his renewal lands on a temporary low point in the market (talk about leaving things to chance), or if rates spike very aggressively for a short period of time and fall back. Sometimes lowest cost and flexibility is not the main priority but rather payment stability the priority. In this situation a fixed rate can make sense. An alternative to this would be a “variable” rate mortgage where the interest rate adjusts but your payments stay the same.
Why do I often suggest Variable Rate mortgages?
The moral of the story – historically variable products have outperformed fixed rate products. I do not expect this to change. One study by Dr. Moshe Milevsky showed that “variable rate-mortgages saved borrowers money 88.6% of the time.” when compared to fixed rate mortgages.
Over 25 years you will have an average interest cost, a variable mortgage will adjust often, up and down, whereas with a fixed-rate mortgage you will have a new rate set for years 1,5,10,15,20, and 25.
To avoid massive penalties, avoid potential rate shock on my renewal, and hopefully have a lower interest cost in the long run I am staying variable. You will need to decide for your own family but I hope this helps.
