In business school and doing individual research I always came across the same piece of advice “fixed rates are better when interest rates are on the rise and variable rates are better when interest rates are on the decline”. A good-enough piece of advice for a 19-year-old business student who just ate leftover Mac and Cheese for breakfast.
The question of “fixed vs. variable” requires a lot more in-depth consideration than a quick one sentence summary. People don’t analyze both sides in enough detail because they don’t realize how much money can be saved or lost in the process.
Before I give my opinion on fixed vs variable rates, I want to add that I don’t have a crystal ball and I don’t know exactly what rates will do. What I do have is an opinion that’s backed by a lot of data.
I believe variable rates are the way to go from a money saving standpoint!
But you may ask “Aren’t rates on the rise and aren’t the majority of Canadian mortgages fixed? Yes, and yes.
Personally, I’m not as concerned about the status quo. I care about what keeps the most amount of money in my client’s pocket.
Reason 1: Lower Rates
Look at the variable vs fixed rates question as a bet. If you’re choosing a fixed rate mortgage, you’re betting that the prime rate will increase by around 2% or more by the end of the term.
Variable rates increase and decrease with the prime rate so if the government raises the prime rate by 0.25%, your variable rate will also increase by 0.25%.
2% is the number because as of right now there is around a 2% difference between a fixed and a variable rate. For example, one of my favourite lenders has a fixed rate of 4.19% for a 5-year high ratio mortgage (the most common mortgage for a first-time home buyer). The variable rate on the exact same mortgage is 2.3% which is a 1.89% difference at the time of writing (May 17th).
Because the government almost always raises rates by increments of 0.25% it would take 7 to 8 rate hikes for the variable rate to be higher than the fixed rate (0.25% x 8 = 2%). I know the last 2 rate hikes were 0.5% but those were very rare. The 0.5% hikes are proof to what I said above “I don’t have a crystal ball and I don’t know exactly what rates will do”.
Let’s say that there will be 8 more rate hikes over the next 5 years, the same amount of time as your hypothetical term. I don’t think that will happen and if you do some research, you will probably agree. Now I know what your thinking, “ok so if there are 8 rate hikes in the next 5 years then variable and fixed must be equal”… Wrong!
In the time it took for the rate hikes to happen, you have been saving money with your variable rate. Say it took 3 years for the prime rate to hike 8 times. Your variable would be costing you more in the last 2 years, but you had 3 years of saving. This could be thousands of dollars of savings.
It would take 8, 9 or even 10 rate hikes over your term for your variable rate to cost you money. Will the prime rate increase 2 – 2.5% over the next few years? Who knows… but probably not.
Now what if the Bank of Canada hikes rates less than 8 times? Well that means you would be saving money for the entirety of your term with a variable rate mortgage. Sounds good right? Just wait, it gets better.
Reason 2: Lower Breakage Fee’s
Variable rates normally have lower breakage fees! Not default penalties, breakage fees. Breaking a mortgage is simply when you want to break your contact for whatever your personal reason is, maybe you need to sell or refinance.
In most situations fixed mortgages calculate breakage fees using the higher amount of IRD or 3 months interest. From my experience IRD calculations will almost always be more than 3 months interest so fixed mortgages almost always use IRD. I could write a separate blog about IRD so to keep it simple, just think IRD = a complex lender dependant calculation.
3-month interest is simple. It’s just 3 months interest on the remaining balance allowing variable rate mortgage holders to not worry about breakage fees as much.
Reason 3: Cash Flow
Your last worry about fixed rates might be that you don’t want your payment to increase when you’re on a tight budget. I get it, mortgages are traditionally a homeowner’s biggest debt; however, most lenders offer a set payment just like a fixed and the only thing that would change is the amount that is paid toward principal and interest.
So, if your payment is $2000 a month and you currently pay $1500 of that to principal and $500 to interest then raising rates might change it to $1400 to principal and $600 to interest. The payment amount would be the same for budgeting purposes and only the principal/ interest amounts within would change.
The 3 reasons stated above are good reasons to choose a variable rate but they aren’t everything!
In my opinion mortgages are just as much about well being as they are about monetary gain. If a fixed rate lowers stress and helps you sleep at night, then the saying “no price on peace of mind” is particularly true. Also, for certain types of mortgages and financial situations a variable might not be beneficial or even offered so it’s important to have a chat with your mortgage broker (hopefully me) before hand.