Variable Rates Quite Relevant, Still

Whenever rate-hike talk starts heating up (like it has since Friday) questions about term selection become more frequent.

People increasingly want to know if the next prime rate increase is their cue to lock in.

The criteria for choosing between a fixed and variable rate have been covered here before, so we won’t bore anyone with repetition (see: Variable or Fixed Rate Mortgage, IDEAS for more on that). 

As any mortgage professional will attest, it’s impossible to make a one-size-fits-all recommendation because the fixed/variable decision is so individual-specific.

What we can do, however, is show how things might shake out from a purely mathematical standpoint if economist forecasts are right (they often aren’t right, but that’s a separate conversation). 

As noted this past weekend, big bank projections imply a 4.50% prime rate by year-end 2011 (see: Long-term Mortgage Rate Forecast). In our own models, we’ve been tacking on another 1/2 point increase as a safety measure, and to reflect what might happen after 2011. Incidentally, the 10-year average for prime rate is 4.72%.

As of July 14, 2010, our current fixed vs. variable model also assumes:

• A highly discounted variable rate (prime – 0.65%)
• A highly discounted fixed rate (3.99%).
• A well-qualified borrower with satisfactory credit, equity, savings, job stability, debt ratios, etc.
• A BoC rate hike pause in early 2011 (to let the U.S. Federal Reserve catch up to the BoC’s overnight rate). 
  
  As usual, rate-change assumptions are based on the projections of major analysts, who presumably have less chance of being wrong than the average Joe.

With these and a few other parameters, one can generate an amortization comparison between a fixed and variable-rate mortgage. That, in turn, can illustrate which of the two hypothetically saves you the most money over five years.

Based on the above assumptions, the variable-rate mortgage comes out ahead of the 5-year fixed, by about $498 over five years for every $100,000 of mortgage. (Sample Analysis)

Therefore, risk-tolerant homeowners (even semi-risk-tolerant homeowners) are potentially doing themselves a disservice by locking in 100% of their mortgage to a long term (like 4 to 10 years).

Granted, there are plenty of caveats. It’s therefore essential to talk things over with a mortgage professional and have him/her run these numbers using assumptions that each of you feel comfortable with.

As well, this article only compares two terms:  a variable and a 5-year fixed. Your mortgage planner, however, might be able to suggest a shorter-term fixed mortgage that is even more preferable than a variable rate.

Suffice it to say, long-term fixed rates haven’t relegated variable rates to irrelevancy, despite the possibility of higher rates right around the corner.  Most strong borrowers should still consider putting at least part of their mortgage in a variable or short-term rate.