By: Ian Mucignat
A few years ago, I wrote about the “great debate”, whether it makes sense to choose fixed rate or variable rate – read here.
Empirically speaking, studies have shown that variable rate clients win about 85%. A win means they paid less interest over the term of the mortgage. However, it’s important to note that not everyone is cut out to be a variable rate client. Specifically, there is the risk that the rate and mortgage payment will increase suddenly. Therefore, you need to be comfortable with this risk and be able to sleep knowing your payment can increase.
Given a normal positively sloped yield curve, a variable rate mortgage will have an interest rate that is lower at inception. Variable rate mortgages are linked to the institution’s Prime Rate and are usually given a discount. For example, if the Prime Rate is 3.45% and the discount is 1.00%, then the mortgage rate is 2.45%. Two months from now, the Prime rate might increase to 3.70% because the Bank of Canada increased its overnight rate, so the rate on your mortgage increases to 2.70%.
A fixed mortgage rate is set at the beginning and doesn’t change during the course of the term.
Putting personal risk tolerances and biases aside, what do the numbers say today? Let’s take a look at a predictive model I use with my clients:
$500,000 mortgage, 25-year amortization, 5 year term
- Fixed choice: 3.39%
- Variable choice: Prime minus 1.00% = 2.45% today
So, who wins? To answer this question, we need a viewpoint of Prime Rate.
Prime rate History
First, below is a graph of the prime rate from 1937 to today. This much history is not very useful because of how our currency and inflation were pegged early on. Then, in the 70’s and 80’s, the central banks let inflation ride wild. Starting in the early 90’s, the policy makers realized a low, stable inflation rate is ideal for economic growth.
Today, the Bank of Canada’s website states: “The objective of monetary policy is to preserve the value of money by keeping inflation low, stable and predictable.” Therefore, let’s look at the graph of the early 90’s to today and make some observations.
It’s interesting to note that movements in the prime rate tend to look like a staircase. Once they start moving in a set direction, they tend to keep moving in the same direction.
During periods of economic turmoil, we see the rates drop quickly by about 3.75%. As a variable rate mortgage holder, you would like this!
- The staircase down from November 2000 to March 2002 took less than 2 years, and the rate moved 3.75% total.
- The staircase down from November 2007 to June 2009 took less than 2 years and moved 3.75%. This was after the major credit crisis.
During periods of growth, we see rates ratchet up by about 2.6% over the course of 3 years. This is when variable rate mortgagors lose!
- The staircase up from 1997 to mid-2000 took about 3 years and went up 2.75%.
- The staircase up from August 2004 to November 2007 took another 3 years and went up 2.5%.
From June 2009 to July 2017, a period of 8 years, we have seen rates rise and fall a little but basically stay flat. After the “great recession”, as some call it, the economy stumbled, and it took a long time to recover. Variable rate mortgage holders would have done well during this period!
Moving forward from today
As the joke goes, did you know economists have predicted nine out of the last five recessions? Seriously. Economists are notorious for being wrong.
There are actually two laws of economists. The First Law of Economists: For every economist, there exists an equal and opposite economist. The Second Law of Economists: They're both wrong.
That being said, let’s look at three scenarios that I think could potentially happen:
- Flat Rate Scenario– Trumponics puts us into a recession soon. Yes, this can actually happen. In fact, there are well-respected economists predicting this will happen in the next 12 months! See this articlefrom the Globe and Mail.
- Increasing prime rate slowly Scenario– This seems to be the most realistic scenario. The Bank of Canada has quite openly communicated its concern about raising rates too quickly and shown real concern for the debt load of Canadians. They are worried about the sensitivity of rates rising too quickly.
- Increasing quickly staircase– From a historical graph standpoint, we know rates can rise fairly quickly. We saw this earlier in this article. Let’s say we have continuous upwards rate hikes of 00% total from the time they started, July 2017, which is more aggressive than our historical graph. In this case, we can expect rates to rise another 2.25%.
Summary of Results
Running the numbers shows that a flat or slowly increasing prime rate leads to variable rate mortgage holders paying less interest by 22K and 6K. However, a scenario also exists where rates might rise more quickly, and variable rate clients pay 18K extra.
Not to bash on economists too much, but I have seen economists make wrong predictions many times. I have seen the head of mortgages at a major Canadian bank take a fixed rate on his own mortgage in 2011 because the head economist advised him that rates were going up. Even the Bank of Canada acknowledges that any change they make today can take years to develop.
Bottom line, nothing has changed. In all likelihood, you will save more money with a variable rate mortgage. Empirically speaking, we know this too. However, it’s important that you can absorb the payment increases and sleep well at night because a scenario does exist where you are worse off. Furthermore, you need to be able to make your payment on time every month. This is the risk-reward relationship.
Keep calm and mortgage on.
About the Author:
Ian Mucignat, CFA, is an independent mortgage agent at TMG The Mortgage Group. He graduated from Wilfrid Laurier University with a Bachelor of Business Administration, minoring in Economics, and is a CFA Charterholder. Ian has worked in the mortgage industry since 2000 at lenders, banks, and brokerages. If you are purchasing, renewing, or refinancing your mortgage, don’t hesitate to contact Ian directly for a free consultation.