I.D.E.A.S. For Choosing Between A Fixed And Variable Rate



Best-Mortgage-termsThe first question people often ask when deciding between a fixed and variable mortgage is: “Where do you see rates going?”  

They assume we as mortgage planners know…and of course we don’t.  No one does. 

We can, and do, present a variety of possible rate scenarios based on:

  • where we are in the rate cycle
  • how rates have performed after past recessions
  • and other available research.

But you never know for sure where the rate setters (the Bank of Canada and bond traders) will take the market.

Aside from reading the tea leaves on rates, the best thing a borrower can do is measure his/her ability to handle rising payments. To gauge that, we use a handy acronym called IDEAS.

IDEAS stands for Income, Debt, Equity, Assets, Sensitivity to Risk.

More specifically:

  • Income — Is the borrower’s income stable and reliable?
    • Is there a low chance of income interruption?  (You don’t want payments to soar if there’s a chance you’ll be out of a job for a while)
    • Does the borrower earn enough to pay his/her variable-rate mortgage as if it were a 5-year fixed mortgage? (i.e.,  Can he/she afford to set his/her payments higher to offset the effect of rising rates?)
  • Debt — Does the client have a reasonable debt ratio?
    • Is the person’s total debt ratio under 40% based on the posted 5-year fixed qualification rate (so that his/her budget isn’t crushed if prime rate jumps to 6.25% or more)?
    • Can the borrower withstand 50% higher payments if rates rocketed up 4%?
  • Equity — Does the client have enough equity?
    • Is the loan-to-value under 80-85% so the person could refinance if absolutely needed?
  • Assets — Does the client have enough assets?
    • Preferably 6 months of living expenses (in liquid assets) to act as a payment buffer if needed.
    • Does the person have a credit line as a backup source of liquidity?
  • Sensitivity (to Risk) — Can the client accept risk?
    • If rates increase 2.50%, can he/she handle payments rising over 30%? What if rates jump 4%?
    • Does he/she understand that a fixed rate will save him/her more money up to 23% of the time–according to popular research? (Fixed or Variable)

If most, or all, of the answers to the above are affirmative, a variable rate is something the homeowner can entertain.

After evaluating someone against the IDEAS measure, we then discuss (among other things):

  • The probability they'll need to break their mortgage early or increase it before maturity (each of which could impact their total borrowing cost due to differences in fixed and variable penalties)
  • Future interest rate scenarios, and how rising rates could impact payments and amortization time.
  • The tools that variable rate holders can use to deal with payment risk, like “hold-the-payment” features (which don’t eliminate payment risk entirely) and hybrid mortgages.
  • The pros and cons of relying on a rate conversion (i.e.,  locking in a variable rate)
  • The cost comparison of variable versus fixed terms, based on future rate assumptions.

For most people, the decision between fixed and variable will either save them thousands or cost them thousands.  The goal is to try and take as much of the gamble out of the equation as possible.

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Comments

  1. Comment avatar

    jim    

    Very good article very useful, jim

     
  2. Comment avatar

    Dan    

    RBC has raised by 60 bps!
    The mortgage rate party is over … why is there no article on that here?

     
  3. Comment avatar

    bob    

    Dan,
    Are you paying anyone on this site for specific information related to rates? If not, then why do you think you are entitled to dictate the content of the site?
    Rob and Melanie provide a great site — for free to readers.
    Perhaps they haven’t had time to blog the newest rate rises (this blog isn’t their full time paying job, after all) Perhaps they figure rates are covered well enough elsewhere. Perhaps they just don’t feel like it today . . .
    If you don’t like the content as it comes — publish your own blog. Or at least have the humility to *request* or *suggest* ideas for posts rather than complain that they aren’t posting what *you* think they ought to be posting.

     
  4. Comment avatar

    ForWhomTheTollBuilds    

    As a rule, the better a job you do providing free content, the more hard done by people feel they are.
    I once worked for a company that made one of those free internet speed tests. We used to get angry messages from people who thought we were responsible for poor results because they mistook us for their ISP.
    One time a guy wrote to tell us that he had ordered his pizza over 40 minutes ago and why the hell wasn’t it delivered yet?
    Dealing with the public is fun.
    Good times.

     
  5. Comment avatar

    jim    

    They do there best jobs they can, the mortgage people are going crazy with everyone looking to get lock in at a cheaper rate. I would not like to be in there shoes at all. Good work keep it up. jim

     
  6. Comment avatar

    Bala Vanumamalai    

    We should wait and see how bank of Canada will act on this rising issue.

     
  7. Comment avatar

    Irfan Rahman    

    Excellent article. Thanks.

     
  8. Comment avatar

    suzie    

    I understand the terms but am lost in what to do…which makes me very confused. I paid the penalty to get out of the remaining 2 years of my fixed mortgage. This ended up being around $3000 and now I am in a variable product which is prime -.15. I’m wondering if I should lock in to the rate I secure at 3.9% expiring at the end of June. I really like the new lower payments but am not in a position to accept it if the variable rate jumps over the years. Any advise?

     
  9. Comment avatar

    suzie    

    Should I go for a hybrid? 50% fixed at 3.9% and 50% at variable 2.10?
    Thanks!
    PS: Love your site and the info posted here.

     
  10. Comment avatar

    Robert McLister    

    Hi Suzie, Thanks for the nice comment on the site. Hybrids are a great fit for a lot of people–specifically people who can’t afford all the risk of a floating-rate mortgage. Whether it’s right for you depends on how much payment risk you can take with 1/2 your mortgage (or whatever portion you allocate to a variable rate). It would be best to chat with your mortgage advisor and have him/her do the numbers for you. There’s a ton of factors that go into advising someone on something like this properly–too many for this forum unfortunately. 🙁
    Cheers, – Rob

     
  11. Comment avatar

    suzie    

    True…but why is it that I don’t trust my bank’s mortgage advisor? I feel like she’s advising in the banks interest and benefit more than mine. Do others feel the same?

     
  12. Comment avatar

    Trish    

    So true… renewing in July and deeply engrossed in the variable vs fixed debate. I’m focusing on educating myself as much as possible on the myriad of products in order to make an informed decision rather than blindly following our current bank or our mortgage broker’s advice. Pre-approved at 3.99/5yrs fixed but considering either a hybrid or full variable so hoping to have our broker and bank provide the data.. Ultimately, we’re the experts on our own risk tolerance and how tight we are willing to squeeze our budget to save interest in the long run.

     
  13. Comment avatar

    Rebecca    

    I wish I could get 3.99%. The best my broker can get me today is 4.34%.
    With rates going up I don’t think the “head start” of a variable is worth it. If prime rate was at 5% then I’d definitely choose a variable, but not today.
    Just my opinion

     
  14. Comment avatar

    Paul Hendricks    

    I would not give up 3.99%. That is just 1/2% away from the lowest rate in history. A low fixed rate like that eliminates all risk for 5 years. People who have any doubt about where rates go from here have not studied history. It is not a matter of “if” rates go up. It is only a question of how much. Who of us here thinks they are smart enough to guess “how much?”

     
  15. Comment avatar

    Simon    

    I went to see my RBC financial planner this afternoon. She did a quick check and was still able to offer me a 2.99% – 4 years fixed rate. It’s still available for some clients. It’s worth checking with your banker.

     
  16. Comment avatar

    Maureen    

    I locked in @ 2.99% for 4 years 1 month ago with Royal Bank. I switched banks after 15 years – my first time ever with RBC and I must say I am receiving the ROYAL treatment.

     
  17. Comment avatar

    Vlad    

    I am surprised – people here mantion 3.99% or 4.34%… But I locked 2.39% 4 years fixed for 2 months to renew my mortgage with “RMG mortgages” in February, 2012.
    I wander if I am missing some hidden pitfall here?

     
  18. Comment avatar

    Bret dobbin    

    Excellent article, rob and melanie … By the way, who are the idiots that keep clanging on about rates? I pity the mortgage broker that only focuses on rates instead of educating the client, helping the clients access mortgages that work for them and match their specific needs, and understanding that rate is the last item to be discussed with a client.
    Keep up the good work, folks at CMT.
    Bret.Dobbin@MtgArc.ca

     
  19. Comment avatar

    brokerless in Surrey    

    Thousands of thanks for running this site !!
    I’m what you could refer to as an amateur speculator, Just sold my first of many(fingers crossed.) I need a quick answer : are variable rate mortgages portable ? Willing to pay for it–or rather let my lender handle all that.
    Hopeing the chances of meeting an above average broker on this site are greater then chosing from a menu like list some where else on the web.
    cheers,
    Raj
    Surrey, BC

     
  20. Comment avatar

    no longer broker less    

    finally found a broker !!
    refererd by my sis – why so hard to find a broker on ones own….
    She actually qualified me for two mortgages, so I can flip at twice the rate…
    Its party time in surrey

     
  21. Comment avatar

    Jonathan    

    The IDEAS acronym seems pretty handy, particularly for people who are not familiar with how mortgages and rates work. I’ll be using this for older people!

     

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