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.

[Dave]

Some thoughts on Milevsky's research...

-Today we can usually find a 20%+ discount of the posted "conventional 5 year mortgage". Was that always the case during the 1950-2000 period? My guess is not?

-Similarly, we can now usually find a .6% or higher discount off the prime rate. Does anyone know of variable vs fixed analysis done based upon today's mortgages? (ie applying the fixed 20% discount, & the prime minus 0.6% back historically)

Conceptually, one is only going to come out ahead with the fixed rate if rates rise over the 5 years?

And similarly will benefit with the floating rate if rates are stable or decrease over the 5 years?

So considering that rates are historically low at the moment, and that most people see rates rising over the next five years, I presume that gives more weight the value of a fixed rate?

[Canadian Mortgage]

Hi Dave,

Thanks for the comments. You're right that discounts are greater today than they have been in the past--for both fixed and variable rates. You're also right about the past statistical advantage of variable rates, even if we factor in today's discounts.

Going forward, despite economists talking about rising rates, they're often wrong. Virtually no one in the world can predict rates 6+ months out with significant consistency. There are just too many unknown economic variables to account for.

Given the above, it makes sense for most financially-stable clients to rely on the research and go variable. Rates may go up, but they may then go down as well. The 5-year weighted average is important when projecting. Keep in mind also that low rates in the beginning have a compounded benefit in later years of the term.

Cheers,
Rob

[Dave]

Rob,

Ok, thanks for the feedback.

One final question:

What prevents a a homebuyer from getting pre-approved for a 3-4 month rate guarantee mortgage, and then if rates go down simply re-applying with the same or a different lender to benefit from the lower rate, or from going with a variable mortgage instead?

Dave

[Canadian Mortgage]

There's nothing to prevent it.

Naturally, if the lender you applied with initially drops their rates you usually get the lower rate (unless it's a quick close promotion limited to new applications).

Rob

[Gina]

As a single new home buyer, it is a concern that accepting a floating rate mortgage. You read all the forclosings in the USA and you can't help but wonder, whats going to happen in Canada. Clearly, floating mortages are better for long run, but how safe is it when the USA is clearly hitting some ruff times.

[Jason]

How does the Smith Manoeuver (Maneuver) factor into the fixed vs.variable debate? As I understand it, if the interest is tax deductible the debate between the two becomes moot. (The question may be naive; when answering keep in mind I am naive.)

[Kevin]

The fixed vs. variable decision is generally a separate matter from the Smith Manoeuvre. Based on past statistics, you will likely save interest choosing a variable. Also, with a variable your tax deduction would be lower but you would theoretically pay off your mortgage faster.

[JW]

Hi,

For the past almost 10 years I've had a mortgage, I have gone with a fixed-rate for the comfort level associated with it.

But now that I have a family (and fairly recently a child, resulting in reduced maternity leave income and my wife soon going back to work only part-time or not at all soon if possible), we are highly considering a variable rate mortgage in order to reap the savings of a couple hundred dollars per month in our case (at least from our current fixed rate of 5.43 to a prime minus 0.6% variable rate).

From all the research I've done with respect to variabe rate mortgages, particularly what affects and determines them, I've learned quite a lot ...but also become more confused in some ways. Maybe someone can help clarify things for me?

Here's my understanding: The Bank of Canada rate (which essentially determines the prime rate for banks, that in turn sets variable mortgage rates based on prime) will typically only increase during times of excessive (or continually high) inflation.

And so, would variable rate mortgage not be great options (in the relative short term) for the following two reasons?

1) Due to the recent cooling of Canada's economy and reduced rate of inflation.

2) Despite the recent cooling of Canada's economy (and inflation), the fact that the rate hasn't increased dramatically in the past bunch of years during a strong economy, leads me to believe it's not likely to increase at all or at least significant in the near future or even next couple/few years.

That said, I know the crash in the late 80's/early 90's (caused by the huge 5% or so interest rate increase within a year) was caused by recession.

So it seems to me as though the current downturn in our economy is good for variable rate mortgages right now, but I worry that if our economy worsens (based on the apparent uncertainty and chaos in the markets and U.S. economy) leading to possible recession, that rates could go quickly go a lot higher. And I suppose this is ultimately where I've become confused ...making the decision to go with a variable-rate mortgage or not tough. We're okay with weathering marginal changes/increases to prime, but not major ones.

Sorry for this long-winded post, but thanks for listening.

Jason

[Greg]

I would be interested in hearing some expert feedback on Jasons comment. I am on a variable rate mortgage right now and have been for the past five years (quite happily) but I am concerned about a possible rapid rise in the interest rate also. I don't know enough about how all the economic dots are connected. I think what my main concern is that while lending institutions base thier prime rate on the Bank of Canadas prime rate, they are free to raise thier prime rate without the Bank of Canada rasing theirs. Is that likely??? I can not see the Bank of Canada raising thier rate right now but if our financial instituions find themselves in the same troubles many in the States have, they may raise thier prime rate as a matter of survival. I know of Financial sector is very different than that in the States but I don't know enough to make a good decision....any comments welcome....

[Kyle]

If the lender start raising prime rate "just because", I feel that it is very unethical for them. I wonder how much business they will loose if they ever do that. I can say that if they do that, I will not renew my mortgage with that particular bank or lender.

[Canadian Mortgage]

Hi Jason,

Everyone's worst fear when considering a variable-rate mortgage is a repeat of the early 1980s. No one wants to be stuck with a 10-15% mortgage.

Could rates go that high in this era? Theoretically yes, but few predict it and many outright dismiss it. Central bankers have learned a lot about inflation in the past 25 years, including how to better fight it. Furthermore, the out-of-control prices seen in the 70s and 80s would be hard to replicate in an era where 2.5% inflation puts the Bank of Canada on alert. (As a side note: Regarding your question, recessions usually don’t lead to higher interest rates.)

All this said, anyone in a variable should be prepared for a potential increase of at least 2-3% in their interest rate. That can increase a mortgage payment 20-30%. If you can comfortably handle that, and have some equity in your house, a variable might be the way to go. Talk to a mortgage planner to confirm.

Greg,

It is very unusual for banks to raise their prime rate separate from the Bank of Canada. For the past 10 years they’ve moved in lockstep with each other. It could happen (and will happen again some day), but the odds are greatly against it at any given time.

Cheers,
Rob

[JW]

Thanks Rob.

I've been hearing a lot of talk about the likelyhood of the prime interest rate being cut in both the U.S. and Canada in the near future. But I also recently read that "banks are paying such high interest charges relative to government bonds and central banks' overnight lending rates.".

Wouldn't this latter fact put pressure on the Bank of Canada to increase prime? Or are the banks fine with simply raising their rates on top of prime (i.e. as TD Canada Trust and RBC both recently have ...for example, a variable-rate mortgage with TD Canada Trust is now prime + 1% and the same rate now applies to their home equity lines of credit)?

Greg mentioned his concern about the prime rate (of banks) potentially increasing as a matter of survival if things get really bad. As that action is apparently very unlikely (i.e. as banks typically "move in lockstep with each other"), is it likely that the the BOC would step in to help by increasing prime?

I know there's a lot of factors at play, but I'm trying to understand how my variable-rate mortgage will be affected by this downturn in our economy (possibly recession) until late 2009 or early 2010 when many economists seem to think both Canada and the U.S. will slowly begin to recover (understanding that Canada's econonic downturn is likely going to be much less dire than in the U.S.)?

Despite the increasing challenges (and costs) banks are facing (obviously in the U.S. but also now in Canada), will the BOC prime rate continue to decrease? If so, why? And what types of econonic conditions would trigger it to increase?

Thanks,

Jason

[Canadian Mortgage]

Hi Jason, Man-O-man, it's been a long day. This answer will take more than a few keystrokes so if you don't mind, give me a call sometime and we can chat about it. 800-280-2460.... Cheers, - Rob

[Bob]

One excellent option that I rarely see discussed is a Variable Rate Mortgage with a Fixed Payment Schedule.

Here is how it works (I'll use the National Bank figures because they are what I'm most familiar with -- but most other lenders have the same or similar option):

Although you have a VRM, your payments are fixed at the same $$/month as what they would be if you had a regular 5-year undiscounted mortgage (i.e., 7.2% right now at National Bank).

But the ACTUAL interest rate you pay is your discounted prime rate (i.e., currently Prime minus 0.25=4.00 at National Bank, but can change month to month).

So, for the moment, you are paying a rate of 7.2%, but your ACTUAL interest rate is only 4%.

Advantages:
(1) All of the difference between the actual variable rate (i.e. 4% currently) and the fixed rate (7.2%) is applied directly to principal, so you're paying the whole thing down faster. This makes a HUGE difference in the early years of a mortgage. Depending on what rates do, it is entirely possible to pay off your mortgage in half the time.
(2) Unlike a fixed mortgage, you aren't paying premium interest just so your payment is the same every month.
(3) You are protected against interest rate hikes. In the current example, rates would have to go up 3.2% before your payments would have to rise. That's a pretty substantial rise. In the meantime, as mentioned, the difference all goes straight to principal and so acts like bonus payments.

If you are still unsure, you can also get a "capped variable rate" in which case the rate can only rise to 7.2% and no higher. In this case, your Prime rate is not discounted (Prime+0.00), but you get the peace of mind knowing that not only will your payments never rise, but you will ALWAYS be paying off more principal than you need to, unless rates rise up to the 7.2%, at which case you are paying exactly what you would be paying normally.

Disadvantages
1) if you want to move or otherwise break your mortgage contract before it's over, penalties can be more than other flavours of mortgages
2) since your payments will be based on the undiscounted 5-year rate rather than the present rate, you won't be able to borrow as much (i.e. buy as big a house). Honestly, I see this as a feature not a but -- if you want a house that you can only afford if the interest rate is 4%, not 7%, then you're crazy anyway.

[Canadian Mortgage]

Hi Bob, Thanks for the post. This is a good strategy if your cash flow permits it.

[Adrian]

I currently have a variable at prime -.375% - I have the option to lock in at 5.65% (until next week). What should I do????

Should I wait for rates to start going up and hope to lock in at a decent rate (<6.0%) or should I lock in now?

[Brent]

I have a 3% variable open mortgage rate and I hope it drops on Jan 20/09 by another 0.5%-0.75% If they do, would that be an ideal time to lock in?

Eventually with all of the bailout money being pumped into the system, we will see inflation which could drive borrowing rates into double digits. The question is, "When to renew?"

Thanks,
Brent in Calgary

[Canadian Mortgage]

Hi Brent,

Thanks for the post. Rate timing is not our forte. In fact, we don't know anyone who can do it well consistently.

If you like, you can try to watch 5-year bond yields. If they spike it usually foretells a rise in fixed rates. Or you can listen to the big economists (they expect the same to lower rates through the beginning of 2009)...for what that's worth.

The sad truth is that mere mortals usually can't time the credit markets. If they could, everyone would open up bond hedge funds and be rich.

Rob :)

P.S. I have never heard of any credible economist predict the return of double-digit rates--regardless of their inflation estimates. The Bank of Canada is too vigilant to allow it.

[Jason]

Hi Rob,

Are you able to suggest a site where 5-year bond yields can be monitored (and perhaps advise what to look for). The 'bankofcanada.ca' has some info, but I'm not sure of what to reference.

Like Brent, I'm enjoying a great variable rate right now (2.9% at prime - 0.6%), but would like to keep an eye on fixed rates in the event they come down a bit.

However, as it will be hard to justify a possible switch to a fixed-rate (based on my perception of lost savings if prime stays low well into '09 and maybe beyond), I'm wondering what your thoughts are on the prime rate?

I know rates can't be predicted very far out, but with the exception of 1995 (when prime topped out at close to 10%), over the past 14 years prime has historically been (seemingly) on average between 4 and 7.5% or so (and not much above 6% since before 2002).

With 5-year closed fixed rates at around 6-7% right now (at least those offered by RBC and TD), I'm tempted to "ride out" my variable rate despite the moderate stress it causes me in such turbulent times ...as I'm assuming we'd have to have some significant ongoing inflation coming out of recession for prime to eventually rise above say 7-8% (and only then would I be on par or possibly better off with a fixed-rate if I lock in if/when they become available at around 5-5.5%).

Does my reasoning seem relatively sound? If not, feel free to blatantly say so ;) I'm not in the financial sector ...just a guy trying to plan as best as possible for his family with limited knowledge of the factors influencing mortgage rates.

And do you know what happened with the economy in '95 that caused prime to get so high (including fixed 5-year mortgage rates)?

Thanks,

Jason

[nilesh]

Hi Rob

I have just renewed my mortgage with TD with variable 5 year closed.(prime + .80%)which is effective Mar 1 '09. I am getting an offer from other bank for fixed 5 year @4.00%. I talked to my bank and they agreed to give me a rate of 4.09%. I told TD that they should atleast match the rate which other bank is offering me to which they denied. Do you think TD can afford going little lower and that they don't have space to match the rate? In this scneario, my assumptions are that bank of canada to lower the lending rates by .25 -.50. I am more inclined to fixed rate and was just wondering if this is the good time for me to lock in or should i wait until Bank of canada decides the lending rate.

[Canadian Mortgage]

Hi Nilesh,

Thanks for the post. While I can't comment on what TD can afford, I can say that 4.00% (or anything close to that) is an incredible rate for a 5-year fixed. Whether it is suitable for you depends on a host of factors, which your mortgage specialist should be able to analyze for you. If he/she can't then it means you should find someone else to plan your mortgage.

Regarding the Bank of Canada lowering rates, this usually directly affects prime rate. BoC movements do not have as tight a correlation with 5-year fixed rates because those are driven by bond yields. While bond yields and prime move together long term, they very often act independently in the short-term.

Hope this helps. Have a great weekend,

Rob

[Yvonne]

Called in today to see what CIBC would offer if I locked in, asked her to check all mortgages and she said the 5 year was the one she could offer best rate on. 4.29% this morning.......I'm still at .25 below prime til Spring 2013. Guess I'm sticking it out for a while...........but just wanted to share the info