BMO Gives Edge to Variables

BMO released a report on Friday about choosing between fixed and variable-rate mortgages.

BMO says, “Over the past 30 years it has been more cost-effective for borrowers to have a variable-rate mortgage 82% of the time.”

That appears true according to BMO’s assumptions. We did a slightly different test though, and will talk about that in a moment.

There is a problem with these types of studies, however, and that is sample size. There have been very few cases where history resembles today. In fact, we’ve never been witness to a monetary policy rate near 0%. 

Nonetheless, BMO economist, Doug Porter, had this to say in support of variable rates:

• “The current outlook for inflation remains benign, which will likely keep price pressures at bay well into 2011.”
• The difference between 5-year fixed mortgage rates and variable rates “is now close to an all-time high.”
• “There is also some risk to locking in as fixed rates could fall if the economy performs worse than anticipated.”

On the other hand, BMO’s report made several points upholding fixed rates. It said:

• "Short-term rates are at extreme lows and pressure is likely to build for higher rates in the year ahead."
• “The Bank of Canada's overnight rate is now as low as it can go, so there is no further downside for variable rates.”
• “Although inflation hasn't been a problem since 1991, there is a risk of an inflation flare-up as global central banks keep the pedal to the policy metal, and amid record government deficits. The Bank of Canada could be forced to raise interest rates aggressively, driving variable mortgage rates higher, but leaving Canadians with fixed rates unscathed.”
• Fixed rates were beneficial twice in recent history… “through the late 1970s and briefly in the late 1980s.” Both cases were “ahead of a period of rising interest rates, as is the case now.”

That last point is where you can look at things in two ways.  BMO arrived at its conclusions by comparing posted rates to prime rate (their chosen proxies for fixed and variable mortgage rates).  Prime is a good approximation for variable rates but no one pays posted fixed rates anymore.

So we did the same study using discounted fixed rates (i.e., 1.5% off of posted, which seems reasonable).  The results were very different…click on the chart below.

With these assumptions, there were at least six periods in recent history when fixed rates beat variable rates at prime.  Put another way, discounted fixed rates would have outperformed prime rate almost half the time.  (Mind you, if big discounts to prime were available once again, variable rates would fare better.)

BMO declares that the optimal choice “depends on the individual.”  That, of course, is true as always.

Interestingly, if we forget about chart data for a moment, it appears BMO presents more arguments in support of fixed rates than it does for variable rates.  In addition to its comments above, BMO says:

• “The moderate extra cost of peace of mind you can get from a fixed rate may be a price worth paying.”
• “There is also a reasonable scenario where fixed rates may actually prove to be a cheaper alternative at this point.”

Despite all of this, BMO says its “core view” is that:

“The most likely economic and interest rate outlook will ultimately again slightly favour the variable rate option.”

But what does “slightly favour” mean?  If we assume a 55% probability, then it’s little better than a coin flip.

For most people, if they faced a 45% probability of losing money, they’d insure against it.  Fixed rates provide such insurance, and if rates rise 2.5% or more over the next few years, that insurance will start looking pretty good.

Our perspective isn’t meant to be a blanket endorsement of fixed rates, but the above is definitely something to think about if you’re on the fence.