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What is Better: Variable or Fixed Rate Mortgages?

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The debate between variable versus fixed rate mortgages has gone on for a long time. Before we debate which one is better, let’s look at some of the differences and features:

 

Variable Rate Mortgages
The interest rate of a variable rate mortgage floats, which means it can change according to the Bank’s Prime Rate.  As a result, the payments can also change accordingly with less principal and more interest being paid as interest rate increases.  In most cases, the variable rate is lower than a fixed rate but many people do not like to deal with changing mortgage payments.  It creates too much financial uncertainty.

 

Fixed Rate Mortgages
Unlike variable rate mortgages, fixed rate mortgages stay constant or fixed over a specific period of time.  That means your payments, stay the same every month regardless of changes to interest rates.  Most commonly, you can fix rates for 1 to 10 years in Canada.  Generally speaking the longer the term, the higher the interest rate.

Variable vs Fixed Rate Mortgages
In theory, when interest rates fall many experts will argue that variable rate mortgages will save you interest. However, in rising interest rate environments, fear of never ending increases causes people to lock into 5 year fixed rate mortgages.
 

Moshe Milevsky, a Professor of Finance at York University has research showing that mathematically, the variable rate is the better strategy over 88% of the time. In Milevsky’s research paper, he shows that Canadians could save $22,000 of interest payments for every $100,000 of mortgage debt over a 15-year amortization by going with the variable rate option. He used interest rate data from 1950 to 2000 to make his point.
 
What is the spread?
When looking at which is better, it’s important to look at the spread between interest rates.  Currently, the best rates I could find on a variable rate mortgage was 2.30%.  If we compare that to a 5 year fixed ate of 2.99%, the spread between a variable rate and a fixed rate is moderate at 0.69%.  When the spread is low (usually < 0.40), there is a tendency to go with a fixed rate over a variable rate especially with a fear that rates may increase in the future.  Given today’s spread, the price you pay for uncertainty is pretty reasonable. If we look at the numbers, the payments on variable rate mortgage at 2.30% on a $400,000 would mean payments of $1,752 per month.  The total interest over 5 years would be $42,314 and the total interest over a 25 year amortization would be $125,681.
 
The payments on a fixed mortgage at 2.99% would be higher at $1,891 per month.  The interest over 5 years would be $55,289 which is $12,975 more than the variable rate.
 
If you think interest rates will rise over the 5 years, then you may argue that a fixed rate mortgage is better but the real question is how much will they rise?  If interest rates increase 70 basis points to 3.00%, then you would still be better off with the variable rate mortgage.  But if interest rates increase past 3.00% and the average interest rate is higher than 2.99% over the 5-year period then you could argue that the fixed rate is better.
 
For the past 5 years, I have heard over and over again that interest rates have to rise but despite the fear of rising interest rates, rates have stayed the same or even gone lower.  The real problem is no one knows where interest rates will go over the next 5 years.  Many people have guesses or thoughts but no one knows.
 
Pay fixed dollar payments on a variable rate
While many people avoid variable rate mortgages because they don’t like the idea of variable or changing payments, one solid option is to use a variable rate but to make payments as if it were a fixed rate payment.  In this case, you would choose the variable rate of 2.30% but you would make payments of $1,891, which is $139 higher than the required variable rate payment.  This means every month an extra $139 of principle is being paid down.
 
By paying the $1,891 per month at the lower 2.30% interest rate, you would pay off the mortgage faster because every payment has more money going towards the principle.  The mortgage would be paid off in 21 years and 7 months as opposed to 25 years. More importantly, you would save approx. 7% in total interest over the amortization of the mortgage.
 
Rather than try to guess when interest rates will go up or down and by how much, the prudent strategy might be to blend the security of a fixed rate with the benefit of the lower interest.

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