Variable Rates Quite Relevant, Still

Variable-rate-mortgage 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.

  1. Hi Rob:
    Enjoy the site.
    What are decent current rates for an open variable?
    Also, lowering a HELOC rate to prime shouldn’t be an issue for most major banks? Thoughts?
    Thanks,

  2. Any thoughts on letting consumers know how mortgage brokers are compensated?
    Some sceptics may wonder if the advice they’re receiving from their mortgage broker pads the pockets of the broker or the bank instead of it being in the clients’ best interest.

  3. Mortgage associates and brokers have a fiduciary duty to both the lender and the borrower. That means that at all times, the associate must put the interests of the lender ahead of his or her own, and must also put the interests of the borrower ahead of his or her own. As a result of this relationship, full disclosure is required, at least in Alberta, as to how the associate is compensated and by whom. The nature of the borrower-broker-lender relationship must also be disclosed to the borrower.

  4. Hmmmmm,
    generally the broker makes more money the longer the term, and fixed rates usually pay more then variables. But if you don’t trust you broker, by all means go to your bank! They never rip people off! :)
    And Andrew is right, there is full disclosure to the client about what the compensation is, and were it is coming from. Can’t say the same for a bank.
    good luck!

  5. Is this comparison based on sticking to the lower variable payments, or initially putting in the amount that you would with the fixed mortgage? Since you’re considering paying that much anyways it would be interesting to see how much it saves.

  6. Hi Ray,
    Thanks for the note. Most lenders are at prime + 0.70% or prime + 0.80% for open variables. Although, you might be able to do 10-20 basis point better depending on the deal.
    There are banks that could make money at prime on HELOCs, but there’s no motivation to lower HELOC rates because of their revolving nature (higher risk), securitization limitations, demands on a lender’s balance sheet, and because lenders are in a herd mentality (no one wants to cut first).
    Cheers,
    Rob

  7. Blair is right that compensation is scaled by term. On the average mortgage, lenders pay some fraction of one percent depending on the term. This is the primary way mortgage advisors are compensated for the guidance they provide. The consumer never pays a fee to the broker on a prime mortgage. The exception, of course, is with subprime mortgages where brokers must charge separately because lenders often don’t pay placement fees. Provincial regulators each have their own guidelines stipulating how compensation must be disclosed to borrowers.

  8. Hi Richard,
    The latter. We assume the borrower will take the payment savings from the variable and use it to make extra pre-payments (to keep the effective payments the same).
    Thanks for the question,
    Rob

  9. Rob, like the fact that you are comparing apples to apples i.e. average rate (based on forecasts) over the same term… i don’t think many brokers realize that when stating “variable is cheaper than fixed”

  10. Hmmmm,
    There are moral and ethical duties of a mortgage broker. You would find that a broker who is offering you a better rate than an institution directly would. Sometimes they do try to match the rates – remember – not all the time. A broker has his/her ethical duty to both – the borrower and the bank.
    Also as Blair and Andrew said – there is always a complete disclosure.
    Broker compensation rates are also all over the internet.

  11. Opps i meant to post this here not under July 12th…so sorry for the repost…but here is my…Question…we have come to the “almost” conclusion that when we build our new home this fall, we should pay the outrageous penalty ($13000) to break our current mortgage (5.2 % with 2 yrs left) and go variable fixed 5 yr as our port rate is 4.69……what I am wondering is a.any thoughts on this and b. if we did a rate capper, we were told we pay the cap rate the whole time and just more goes to principle/interest based on the rate….is that correct?
    thanks for your help

  12. What is the analysis on bond rates increasing in relation to prime rate increases? Is there a historical trend to reference?
    Based on your estimates for the prime rate then what you say is a good locked rate for the 2-3 year timeframe?

  13. Hi “young couple,”
    Thanks for the post. Your first question is a mortgage planning scenario with lots of variables. So you’re best to call your mortgage advisor on this one. If you don’t have one, here is a mortgage planner directory, or feel free to contact us by email if we can help.
    Regarding your second question, RBC will set your variable payment at a fixed amount each month, and yes, the principal/interest ratio will change as prime changes.
    Keep in mind, if your monthly payment is not enough to cover the interest due, RBC will make an adjustment to ensure you at least pay them the monthly interest.
    Cheers,
    Rob

  14. Hi YC,
    I just did that exact thing. I had 2 years left on a 5.99% fixed term. I wanted to stay with RBC if possible for various reasons. In an effort to lower my total monthly payments in general to have more money to clear some high interest debt, I broke my contract for a penalty of $8000 and went to a rate capper at 2.5% with 4.88% cap (snuck it in just after the new cap rate and just before the next rate increase LOL). They originally offered me a no-penalty blended rate of 5.62% and my 2 year term would not be touched. Not good enough for my goals I said.
    The bank rep I was dealing with had such a fit with me because I was not allowing for large chunks of payments on my principal on this mortgage and as rates rose, I would be paying less and less toward the total debt. But that is not my priority at the moment. For the next 5 years, my goal is to clear and pay down debts and renovate my 25 year old home. When those tasks are done, I plan to get back to paying down the mortgage… just in time for my renewal I suspect… :)
    But could I explain this to her? No sir… She wanted me to set my payment rate at 4.88% and then as rates rose, I would pay down less and less princpal, but from the other “direction” so to speak. BZZZT – again, not what I am trying to acomplish here!!! Be firm with the banks – they seem to push their opinion around a lot, but in the end have to do what you say as long as you qualify.
    Here is a link to a great mortgage spreadsheet. I changed the payment amount to be fixed in my version so I could see how much my principal would whittle away with rising rates.
    http://www.vertex42.com/Calculators/home-mortgage-calculator.html
    Give it a try and work out your details. You can even account in this for rate increases over time, and caps on the interest rate.
    Quite useful.

  15. HELOC Question:
    What is a good rate for a HELOC where it is the only thing on the house? I currently have a Prime + 1% with TD for a HELOC representing about 15% of the house’s price (no other mortgage on it)
    I went with HELOC when I purchased it instead of a conventional mortgage due to the variable nature of my income and our need to do some renos and my desire to pay it off in less than 3-4 years.
    Should I shop around or is 3.5% with the threat of future increases, the going rate? I am in BC.

  16. Hi Westcoast!
    There are two terrific HELOCs at a rate that is 1/2 percentage point cheaper. The better of the two comes with a feature called interest cancellation, multiple sub accounts, free online banking, and a variety of other perks. Any mortgage planner should be able to help you, or feel free to drop us a line as well.
    Cheers,
    Melanie

  17. Just to confirm my understanding of this analysis. For the variable rate, you assume increases but for only 2 years? After that, you assume the rates stay the same.
    If this is the case, how can you compare this to a 5 year fixed, if for 3/5 of the term will see no change in the “variable” rate.
    Perhaps I’m misunderstanding the sample analysis, but I don’t see the value as it is an unlikely scenario.

  18. Hi Matthew,
    Thanks for the note. It’s a very fair question.
    The analysis takes the average bank’s rate increase projection and adds 1/2 point to reflect what might occur after the projection period.
    The assumption is that rates will remain reasonably flat or oscillate such that the average variable rate over the remaining 3/5 of the term is near 4.35%.
    These are arguably reasonable assumptions given the low-growth/low-inflation outlook of most major analysts.
    It’s important to remember that rate simulations are, by definition, hypothetical. Their value is in demonstrating what could result if the assumptions materialize within a given margin of error.
    Of course, mortgage planners also have the tools to adjust these assumptions if your own personal view of things differs.
    Cheers,
    Rob

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