By: Ian Mucignat, CFA
Choosing fixed or variable rate on your next mortgage is an important decision. As we will see below, it’s also not a clear cut decision and requires experienced advice.
Empirical research has shown that shorter term rates are the most economical in terms of saving interest costs. A 2014 report published by BMO Nesbitt Burns states that since 1975, the most cost effective route for borrowers to stay with variable by a resounding 85% of the time.
Variable Rate mortgages:
A variable rate mortgage is based on the lender’s own prime rate. The prime rate is essentially the Bank of Canada’s overnight rate or key interest rate plus two percent. The Bank of Canada reports on the key interest rate on a set schedule of eight times per year. The variable rate on mortgages are quoted as plus or minus something off the lender’s Prime rate, for example, Prime minus 0.75% for 5 years. The Prime rate is defined as the rate at which banks lend to their most credit-worthy customers. When the Prime rate changes so does the mortgage payment.
One very common feature of variable rate mortgages are the ability to convert to a fixed rate at any time at a term that is at least as great as the term remaining. Some people may say this is a good protection or risk mitigation against rising rates. However, the rate to convert into is done at the current prevailing rates. Unfortunately, it’s usually the longer term rates that rise before the Prime rate and so by the time the decision is made to convert to fixed is too late.
To qualify for a variable rate mortgage, applicants must apply at the Bank of Canada qualifying rate and not the rate on the mortgage. The qualifying ratethe time of this writing is 4.79% which makes it tougher for some applicants to get approved.
Fixed Rate mortgage
Fixed rate mortgages are easy. The rate on the mortgage stays the same for the entire term and the payment doesn’t change. Borrowers make payments and prepayments according to the terms registered. What makes them interesting are the differences in the features or rights. It’s important to use caution here because some mortgages have restrictions that can cost the borrower much more at a later date. See No-Frills.
Economic Outlook and the Bank of Canada
The Bank of Canada adjusts their overnight rate depending on their outlook on the economy. At a very high level, they increase the overnight rate to slow the economy during times of booming and high inflation and they lower the rate to help spur the economy. In the latter, they want people and businesses to borrow and make investments.
Given that the Bank of Canada is strongly against high inflation from a policy perspective, it is unlikely that we will see a rapid rise in short term rates for a long time.
Common differences between fixed and variable:
Prepayment penalties are calculated differently. A fixed rate mortgage is calculated as the greater of three months interest or Interest Rate Differential (IRD). A variable rate mortgage can’t have an IRD penalty so it’s common calculation is simply three months interest. This favours borrowers that are relatively certain that they are going to need to break the terms of their mortgage and pay a penalty.
Another difference is that it’s harder to qualify for a variable rate mortgage because mortgage rules in Canada. When a lender qualifies someone for a mortgage they must look at the debt servicing ratios, which include the calculated mortgage payment. Fixed rates may be easier to qualify for they use the fixed mortgage rate, say 2.89% to calculate the payment. A variable rate mortgage must be qualified for at the higher Bank of Canada Qualifying Rate (currently 4.79%), not the actual rate, say 2.3%.
Certain lenders offer the mortgagor an ability to have both a fixed component and a variable component. They also combine a secured line of credit and are registered as a collateral charge. This may be a good option for some to take on the increased risk and reward profile of the variable rate term.
One downside is that the rates offered on the component mortgages may not be the lowest available versus a pure fixed or variable. Also, because they are secured lines of credit, they are registered as collateral a charge, which are a little more difficult to move and negotiate for the best rates at maturity. Some borrowers are not suitable for lines of credit because they view them as an ATM machine and are never able to dig themselves out of debt.
Ultimately, the choice for a combination mortgage is less about rates and more about product features and flexibility, such as investments.
Assessing the decision
There are many questions to ask and factors to consider it’s the whole picture that matters most.
1) What is the tolerance to risk and the desire for certainty?
Variable rate mortgages payments might very well change during the term. For some people, it would be very difficult to sleep at night with a notification from their mortgage lender that their mortgage payment has increased again.
Fixed rate mortgages provide “peace of mind”. It allows the mortgagor to set the payment and almost forget about it. Therefore, it makes budgeting easier because the payment will be the same each time for the remaining term of the mortgage. First time home buyers often prefer this as they navigate through first years of home ownership.
2) What is the financial ability to fend off rate an increase to the mortgage payment?
For some people, their ability service their debts are quite good because they make a great income and have very few debts outstanding. This doesn’t mean they sleep well at night but it does mean they can fend off increases well and take a greater risk.
3) What are the future considerations?
Some households have or certain plans for the future which may make either mortgage more advantageous. For example, a couple that is planning to move into a bigger home with a big mortgage in 2 years should probably take a mortgage product that allows them to the ability to blend the existing terms into the new mortgage.
4) What is the economic outlook?
One thing my education has taught me is that no matter what anyone tells you, you cannot accurate predict the rates. The famously self-proclaimed always right expert, Kevin O’Leary, stated in 2012 that variable rate mortgage holders would be “slaughtered”. Definitely not the case!
However, the Bank of Canada does publish its outlook with clear messages on how they see the economy and the overnight rate to project. It often has valuable nuggets in it that can give comfort to the mid-term economic outlook.
5) What do the projections say?
We know that empirically speaking, variable rates have proven to cost less interest over time. However, using some reasonable assumptions* on the prime rate, what does the bottom line savings say? Is it material and meaningful to you? Is it worth the risk?
*Note - I've used assumptions for economic departments at big Canadian banks. In reality though, they are wrong too, like they have been wrong for the last 4 years!
Example of a variable rate strategy to pay down the mortgage faster
At the beginning, at least, the variable rate payments will be lower than the fixed rate payment. Therefore, set the variable rate mortgage payment to the equivalent fixed rate payment. This does two positive things. First, it helps buffer a borrower’s payment against a rate increase because they will be used to paying the higher amount. Second, it helps pay down the mortgage faster by applying more payment to the principal. Given the wonderful compounding effects, this can be quite significant to the future pay off date!
About the Author:
Ian Mucignat is a mortgage agent at TMG The Mortgage Group. He is an industry expert having served in variety of roles at Canadian schedule I banks and lenders for 14 years, including his last role of Vice President. Ian completed his Chartered Financial Analyst designation and his Bachelor of Business Administration, with a minor in Economics, at Wilfrid Laurier University.