Accumulation and investments Getting the absolute unequivocal undisputed rock-bottom best rate creates sheer pleasure for some.

Choosing the best term is usually secondary.

Anyone who understands an amortization table, however, will tell you without hesitation that these priorities should be completely reversed.

“Beating the system” and squeezing that extra 0.10% of blood from the lender’s stone is dandy. But its a Pyrrhic victory if choosing the wrong term costs you 1/2 point.

That’s why the fixed/variable decision is so imperative.  Taking a fixed mortgage instead of a variable, or vice versa, is a decision that regularly makes or costs the average homeowner thousands and thousands of dollars.

When comparing a fixed and variable mortgage, job #1 is to find someone who can explain all the risks and quantify the benefit of each term.

Besides all the standard analysis that’s involved (see: I.D.E.A.S. For Choosing Between A Fixed and Variable Rate), it’s also essential to understand the math. To help folks visualize the numbers, we use an amortization comparison tool—not unlike that used by other mortgage planners.  It displays the hypothetical interest cost of fixed and variable terms side by side.

quantitative-mortgage-model Of course, with any such analysis, it’s necessary to make key assumptions–despite our knowing full well that the future will deviate from these assumptions. History and the forecasts of professional number crunchers are not infallible, but they’re the best guide we have.  An attempt to logically quantify risk is always better than taking a stab based on gut feel.

At the moment, our model’s assumptions include:

  • A 2.75% jump in prime rate by the end of 2011
    • This is the Big 5 banks’ average forecast, not our prediction.
  • The first hike being a 50 basis point increase on July 20
    • July 20 is the date the financial markets and most economists expect the BoC to start lifting rates. Most speculate that Mark Carney will try to wait until then so he fulfills his April 2009 conditional promise.
    • The actual increase will likely be 25 or 50 bps. No one knows which, but some expect the latter, because pent-up inflationary concerns may force a bigger move if the BoC waits until July 20 to raise rates.
  • Subsequent hikes being 25 bps at each BoC meeting after July 20, with perhaps another 1/2 point hike tossed in…until rates have risen a total of 275 bps (i.e.,  until prime rate hits 5%, give or take)
    • There are 9 rate increases in this model, which is a lot in 19 months. But since there’s no way of knowing the BoC’s intended rate hike increments, we have to assume a somewhat gradual and linear set of increases after July 20.
  • Increases in prime rate (and mortgage payments) take effect on the month following each BoC rate increase
    • In practice, some lenders don’t pass along rate hikes for three months while others pass them along immediately.
  • Prime – .50 and 4.25% are used as proxies for discounted variable and fixed rates respectively
    • Have your mortgage planner run this analysis based on the actual rates available to you at the time.
  • Rates will remain flat after they’ve increased 2.75% by year-end 2011
    • This is a necessary assumption because rates are impossible to predict that far out. Obviously, prime will rise or fall at some point after December 2011.
  • A 5-year term, 35-year amortization, semi-annual compounding, and a $250,000 mortgage amount.

Mortgage-Amortization-Results The result of all this may seem counterintuitive.

Even with prime rate jumping 2.75 percentage points in 19 months, the variable-rate mortgage actually comes out ahead by a few thousand dollars.

See: Fixed vs Variable Amortization Analysis

Again, this analysis is hypothetical so if rates rise less than, or slower than, the above assumptions, you’ll do much better. Of course, the opposite is very true as well.

Always consider the risks of a variable rate (i.e.,  make sure your budget can handle 2-3% higher rates in a few years).

In addition to up-front savings, a variable-rate mortgage puts you even further ahead if you:

  • Select an amortization less than 35 years
  • Set variable payments to match the higher payments of the 5-year fixed mortgage
  • Choose accelerated bi-weekly or accelerated weekly payments–instead of monthly payments
  • Use the monthly payment savings of a variable-rate mortgage to pay off higher-interest debt (like credit cards)

Peter Majthenyi, a mortgage planner of 20 years, says, “It’s not for everyone but if you’re looking at just the math, go variable.”

He says: “We’re not debating about rates going up or down.  The question is: Should I pay the higher rate now, or should I pay it later?  5-6% is a normal rate in a normal economy.”

Going forward, analysts expect the new “normal” to reflect reasonably low long-term inflation.  It is vital (for so many reasons) that this be the case.  If experts are right, this in turn suggests reasonably low long-term interest rates—save for the occasional 1-2 year blip.

Fortunately, the BoC has been doing an exceptional job at keeping inflation subdued ever since it started inflation targeting in 1991. Here’s a chart to this effect, courtesy of the University of Toronto Department of Economics.

On the risk side of the equation, the Bank of Canada could always slip up (we wouldn’t bet on it), global forces could intervene, or bigger default premiums could boost rates in reflection of North America’s sickening reliance on debt.

Nonetheless, exceptions aside, every indication today is that economic growth will be modest and not cause a long-term trend up in inflation. In turn, the Bank of Canada should be able to keep inflation in the 1-3% range over the long haul (which is needed to hold rates in check).

If you’re still worried about variable rates climbing more than 2.75%, there are other options as well:

  • You can put the monthly difference from your lower variable-rate payment in a savings account (or TFSA). That creates a buffer if your mortgage payments jump and you need help making them. (This is meant to be a short-term emergency backup if rates soar beyond expectations. Your budget should really allow for higher payments from the get-go.)
  • You can lessen the risk of a variable by using a readvanceable mortgage. Readvanceables let you borrow money back from the lender on a line of credit. Like the savings account idea, this is a failsafe to help you meet increased variable-rate mortgage payments in the future. The difference is that you’re using the monthly savings to pay down your mortgage instead of plopping them in a low-interest savings account. That gives you a much higher return with no risk, while eliminating tax considerations (you don’t pay tax on interest you save).  Remember though, you need at least 20% equity to get a readvanceable mortgage.
  • You can get a hybrid mortgage (part fixed and part variable).  Putting 50% of your mortgage in a fixed rate cuts your risk in half for the next five years.
  • Take a look at 1-year terms as well. In a rising rate environment a 2.49% fixed rate can beat a 1.75% variable. You then can move into a variable-rate mortgage after the first year if it makes sense at the time.

None of this is to say that variable-rate mortgages are the best bet for everyone. If prime rate rockets up 4% and you go variable, you’ll be a very unhappy camper.

On the other hand, if you’re a numbers person and not prone to hindsight self-flagellation, the risk of a variable may be well worth the reward.