Fixed-Prime Spread At A 30-Year High

The spread (difference) between discounted 5-year fixed and 5-year variable mortgage rates is currently about 240 basis points (bps).

Based on our estimates, (we don’t have historical pricing on discounted fixed and variable rates), that is one of the biggest spreads in a very long time.

If you compare the posted 5-year fixed rate to prime rate, the spread between the two is 360 bps.

That’s the biggest spread in the last 30 years (based on monthly data from the Bank of Canada). Click on the chart below for a close up.

Posted-Prime-Spread

Technically, today’s posted fixed-prime spread is tied with the 360 bps reading we saw last summer.  The difference is that variable rate discounts last summer were nowhere near the prime – .50% we have today.

To put it another way, today's plump fixed-prime spread indicates what many already know:  fixed rates are selling for a major premium over riskier variable rates.

This is not meant to be predictive, but consider this:  If you look back to 1980 for cases where there’s been a 2%+ fixed-prime spread, prime rate has never averaged more than 1.75% higher in the five years that followed.

Will 2010-2015 be the first such instance?  Time will tell.  But one thing’s for certain.  Today’s fixed rates are trading with a huge built-in “insurance premium,” and the 2.40 percentage point edge gives variables a big head start as we move into the next rate hike cycle.

  1. I’m not sure I follow.
    Rather than Fixed Rates trading at a “huge built-in insurance premium”, couldn’t an alternative explanation be that VRM are trading at a *huge built-in discount*.
    After all, to “correct” the spread, it seems more likely that Prime will rise than fixed rates will drop.
    Perhaps the difference is semantic, but in terms of explanation I think the focus should be on the “artificially” low variable rates rather than the apparently “high” fixed rates.

  2. Hi Bob,
    Thanks for the note. “Insurance premium” is more of a non-technical term (an analogy if you will). It describes what customers are, in effect, paying for the security of a fixed rate.
    The intention wasn’t really to comment on whether fixed rates are “high” or variable rates are “low.” It was more of a commentary on the spread between the two.
    Cheers for now,
    Rob

  3. Right, I understand what you are saying and that “insurance premium” is an analogy for the fixed end of the spread, just as my “built-in discount” was an analogy for the variable rate end of the spread.
    But determining whether the spread is a result of “high” fixed rates or “low” variable rates is crucial to answer the question you posed about whether or not prime rate will conform to the historical data (i.e., that it has not averaged more than 1.75% higher in the next five years).
    It seems to me (but perhaps I’m wrong), that in cases where a high spread is caused by high fixed rates then prime likely will not rise much over the next 5 years (i.e., the spread will “normalize” by having fixed rates drop instead). But in cases where a wide spread is caused by atypically low variable rates (as I would argue is currently the case), it seems likely that the spread will “normalize” by having prime rise more than the 1.75% suggested by historical data.
    Does that make sense?

  4. Hi Bob,
    Totally understand where you’re coming from. Your intellectual probing is well warranted.
    That said, the future of prime rate and the catalysts behind a potential contraction in the fixed-prime spread are questions this story didn’t intend to answer (for no other reason than our finite time resources).
    This article was more of an observation on the spread, as opposed to a commentary on why it has got so wide, or where it’s going.
    Nonetheless, it’s an interesting conversation to have. If one were to delve into this topic, you could branch into questions like:
    * Are variable rates really “atypically low” (relative to cost of funds)? And if so, why?
    * Might variable-rate discounts from prime get even better?
    * How might a rise in fixed rates offset a rise in prime?
    * How likely is it that prime rises more than 1.75%?
    * How much of an advantage is the 240 bps “head start” that variables hold over fixed rates?
    * What is the break-even point for a variable-rate mortgage (e.g., how much must prime rise before a fixed rate would have been more cost effective)?
    These are all interesting questions (with potentially lengthy answers). Perhaps we can touch on them more in future posts…
    Cheers for now,
    Rob

  5. I would really like to hear some discussion on the 2 questions below;
    * How much of an advantage is the 240 bps “head start” that variables hold over fixed rates?
    In other words, what is the NPV (or future benefit) of saving interest now, even if it means paying more (than the current fixed rates) later?
    * What is the break-even point for a variable-rate mortgage (e.g., how much must prime rise before a fixed rate would have been more cost effective)?
    Some mathematical information to answer this question would go a long way to understand the variable rate risk vs “it feels like the right thing to do, and history supports it”.

  6. Ross,
    Because it depends on your remaining principal, term remaining, assumptions about where the fixed and variables rates will go over the next 5 years, etc., there is no single answer.
    The best thing to do is just make an ammortization schedule in excel and put in your own numbers to see what will work best in your situation (caution, make sure you use the Canadian interest calculations not the American ones).

  7. Bob is right about the multitude of factors involved. To shed a ray of light on the topic, we’ll try to put a sample scenario together soon. It will provide an example of the potential costs of a variable and fixed mortgage over the next five years given specific assumptions. Any good mortgage planner can run these scenarios as well, using client-specific data.
    Cheers,
    Rob

  8. While running the numbers on fixed vs. variable rates can help you decide which way to go, you still have to make a lot of assumptions about what the future will bring.
    To offer a different perspective, I think it really boils down to whether fear or greed is the your governing instinct.
    If you’re interested in learning more about my theory, here is a link to my blog: http://www.integratedmortgageplanners.com/blog/

  9. Could it be that since we have a number of people racing to secure fixed mortgages before the April 19th deadline when the new rules kick in regarding qualification, that the banks are (heaven forbid) raising their rates to cash in on this group who MUST get approved etc before the 19th? Could it then happen that after April 19th, the rates lower down a bit to previous levels? Could this be the reason behind the “insurance premium” to the fixed rates? A short time here will tell…….

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