The Rate Choice

Should you choose the piece of mind of a fixed rate or the statistical edge of a variable? 

If you ask the experts they'll likely cite the benefits of variable rates but with important caveats, primarily your appetite for risk.

For example...

• In this Business News Network interview, Peter Majthenyi of Mortgage Architects leans towards variable but acknowledges the comfort of fixed rates.
• CIBC economist Benjamin Tal says, "you'd probably still be better off with variable, but don't expect huge benefits. Two or three years ago it was thousands of dollars, but now it's basically peanuts."  Source: Financial Post
• In this MSN Finance article, John Caspar offers a complex economic analysis that makes a good case for both fixed and variable rates.

Comments

[James]

Moshe Milevsky's 2001 original paper which is widely quoted by "experts" as proof that historically you are better off going with a floating rate mortgage is
here. The paper found that during the period 1950-2000, borrowers were better off 88.6% of the time choosing a floating rate mortgage. On a $100,000 mortgage, the average savings was $22,210. On the flip side, a consumer would have lost money by borrowing at the prime rate, compared to the 5-year rate, only 11.4% of the time.

All well and good. However, one point that is rarely mentioned is that variable / floating rate mortgages have only been widely available in Canada from about the mid-1990s. Ipsos Reid / Clayton Research data shows that only 4% of borrowers had variable mortgages in 1999. Wealthy individuals have been able access funds at prime going back to the 50s, however the average joe in Canada never heard of a variable rate mortgage until the 90s. The Canadian Bankers Association website states that in the 1970s only closed fixed term mortgages were widely avialable.

So eventhough on average borrowers would have been better off floating their mortgage from 1950 to 2000, few people were able to benefit because variable products were not widely available. Perhaps 1 year and 6 month mortgages would have allowed marginal savings vs. a 5-year fixed mortgage.

[Melanie]

James,

Very interesting!

Supposing that variable rate mortgages WERE widely available pre-90's do you think that demand for them would have altered Milevsky's findings?

Or do you think Milevsky's research is sufficient in any case to "prove" that most people are better off with a variable rate mortgage?

Melanie

[James]

Milevsky's findings do not depend on the mortgage people actually chose over 1950 to 2000 (survey data, although that would be great). He just uses imaginary cases of 2 borrowers - Linda Long and Shelly Short - and lets the interest rates speak for themselves.

You only have to look at a graph of interest rates from 1950 to 2000 to see that the only time a floating rate mortgage would have really hurt you was in the late 70s, early 80s and late 80s. During those times the prime rate was above the 5-year fixed mortgage rate (page 32 in the paper).

Milevsky states that using a 1-year mortgage vs. 5-year instead of prime vs. the 5-year would not change the results substatially. So to the extent that people used shorter term mortgages like a 1-year fixed they would have reaped similar benefits. However, the 5-year fixed was and continues to be the most popular mortgage in Canada according to CAAMP and others.

Quote from the paper.

"Some might question the wisdom of using the prime rate for our floating (short) rate proxy. Indeed, perhaps the 1-year rate would be more appropriate if the mortgage choice is between a pure 5-year and 1-year term. However, after casual examination of the 1-year numbers (from 1980 - 2000) I found an average difference of approximately 7bps, between prime and the 1-year rate. Figure #5 plots the range of difference between 1-year and 5-year rates and it does vary widely. It reached a high of 175 bps during September 1982, and a low of negative 300 bps during January 1981. However, despite the occasional spike, 65% of the time, the difference between 1-year rates and prime is within plus or minus three quarters of a percentage point."

[Melanie]

Pheww! I'm glad to see the reseach we've been relying on is still valid.

I suppose with today's variable mortgages of Prime - 1% Shelly Short would have come out even further ahead!

[va loans]

Go for the fixed! then you wont be the cause of all these foreclosures!

[Ricker]

Dude, This isn't the U.S. Do you know you're on a Canadian site? We don't have option ARMs up here.