Variables Win Long Term But…

If you had to pick one rate for the rest of your mortgage life, and your only two choices were a 5-year fixed or a 5-year variable, which would you take?

Most mortgage professionals (us included) would take the variable, citing long-term low inflation and historical rate studies, like those found here: Fixed or Variable…

But that doesn’t mean 5-year fixed rates are irrational.  On the contrary, longer-term fixed rates are quite suitable for borrowers who can’t withstand interest rate shocks.

Regardless, rarely a week goes by that we don’t see mortgage professionals paraphrasing studies that show variables are better 88-90% of the time. (In reality, 77% of the time is more accurate, assuming you negotiate good discounts. See this).

Those are good odds any way you slice it.

Yet, people routinely lose sight of the fact that 5-year fixed rates win out 10-23% of the time. That’s important to remember—especially in an environment like today, where prime rate has climbed while fixed rates have become increasingly competitive.

To see how the two rates stack up long-term, have a peek at the historical chart below. It shows simulated mortgage rates going back 30 years. The rates are simulated because today’s discounts are applied to past data.

The chart’s intention is to roughly approximate how fixed and variable rates might have performed over time with aggressive discounting. Moshe Milevsky, the father of Canadian mortgage research, performed his own simulated look-back here.

Fixed-or-Variable-Rate-Mortgage

(Click to enlarge)
In the above chart, the blue line represents the 5-year fixed rate while the white line represents a future moving average of the variable rate.

At any given point, the white line shows what variable rates would have averaged over the following five years. This enables a comparison of fixed and variable rates at specific points in time, using standardized rate discounts.

Naturally, discounts like 0.70% off prime and 1.70% off posted haven’t been around for 30 years. In addition, lender spreads and monetary policy have changed over time, which adds a challenge to normalizing rates (like we’ve done).

Nonetheless, “prime” and “posted” have long been the basis for variable and fixed-rate pricing. The only question is, what discount you choose to apply (it can be argued that past rates could have been significantly more discounted than they were).

At a minimum, the chart shows various times when highly-discounted fixed rates might have performed better than variable rates. That’s true even in cases where the fixed rate was notably higher than the variable rate to start. This seems to happen most often just as prime rate starts increasing from a trough in a rate cycle.

With respect to today’s rate environment, it just so happens that prime rate has started increasing from a trough in a rate cycle.

Long story short, variables are still a great bet for many. But, if you:

  • Have a tight budget
  • Are nervous that prime rate could exceed analyst rate estimates in 18-24 months
  • Find an amazing deal on a 5-year fixed

…then no one can blame you for paying more for the insurance of a fixed rate.  You might get an earful from variable-rate proponents citing their probabilities, but as George Boole once said: “Probability is expectation founded upon partial knowledge.”

  1. There is a lot of fear mongering with regard to payment shock and variable rate mortgages. This article plays into that a little bit as well. I recently negotiated a variable rate mortgage with RBC. The interest rate is 2.35% (prime – .4%). The low payment will stay the same unless interest rates rise to the point where my payments will not cover the interest. The interest trigger point on my mortgage is 7.063%. That is, payments will not rise until the interest trigger point is reached. Prior to that, as interest rates rise, my amortization may increase to cover the shortfall of principle paid. Had I know this years ago, I would have been much more inclined to go with a variable rate mortgage rather than fixed rate. I can easily sleep knowing that, the trigger point at which my payment would rise is a prime interest rate of 7.063%, and in this economic climate that shouldn’t be anytime soon.

  2. nice explanation… i posted a similar chart but excluded the variable rate and only showed the Fixed Rate vs 5-year Future Variable Rate (ex-post) i.e. the variable rate that an individual would have realized over the course of the proceeding 5 years.

  3. The problem with your strategy is that is home values stagnate or move at a more normal 2% per year then you will have paid barely anything when your 5 years are up. Tack on the closing costs and you might actually be the hole if you go to sell the house. You are thinking like many Americans who put 0% down and took low rate mortgages to simply pay interest… it’s all good when home prices are going up but when they dont … you have florida of today

  4. Your are wrong about your trigger rate.
    With a 25 year amortization your payments would increase once your rate exceeded 5.34%, not 7.063%. Where did you get that number by the way?
    With a 35 year amortization rates would only need to exceed 4.22% before your payment would increase.
    Banks who try to sell fixed payment variable rates as the ultimate solution are misleading people at best.

  5. That’s a bit harsh. Most folks are predicting a very slow rise in interest rates over the next few years. When my 5 years are up the amortization may have increased, unless, of course, I make a few payments toward the principle to off-set that. I’m still ahead with the reduction in interest overall. The rate at which home values go up doesn’t impact the amount of principle I have paid, and if I were purchasing a home as an investment that would be a different story.
    If housing prices actually go down, we’ll have bigger problems.

  6. I’m not wrong about the trigger rate. The rate is in the mortgage documents I signed. My amortization is not 25 years or 35 years. This is where the misinformation and fear mongering begins, in my opinion. People who are trying to trudge through this quagmire and make decisions need some concrete scenarios in order to make informed decisions. The broad brush-stroke statements like “payments will rise when interest rates rise” is a misrepresentation and pushes many people toward a fixed rate mortgage.

  7. Hi Sharon,
    Thanks for the feedback.
    The fact is that not all lenders offer fixed-payment variable-rate mortgages. Therefore, payment shock is indeed a valid consideration for:
    * Borrowers who use lenders without fixed payments
    * Borrowers who select short terms (like 1- or 2-year terms)
    * Borrowers who rely on “fixed-payment” variables with trigger rates
    Lenders generally don’t tolerate negative amortization scenarios. Therefore, every fixed-payment variable that I know of has a trigger rate. (If anyone knows of ones that don’t please tell!) As a rough rule of thumb, that means that the borrower’s payment is not in fact fixed if rates rise 2.5-3%. (This depends on individual circumstances, however, so folks are well-advised to run their own scenarios with a mortgage professional as you very correctly suggest.)
    Your trigger rate does seem quite high though. I’m not sure why that is (perhaps you have a short amortization), but it is not standard by any means.
    All this aside, there is still the matter of decreased principal reduction if you take a fixed-payment variable and rates move against you. That impact can potentially cost people thousands of dollars over five years and not everyone is willing to accept that risk.
    Again, while we may side with variables personally, our own views are not appropriate for every borrower.
    Cheers,
    Rob

  8. I’m still sitting on my Prime minus 0.75% variable rate for now. Does anybody think I should start looking at fixed knowing that the BOC will continue to raise rates and all fixed terms appear to be dropping again?
    Doug

  9. Depends on your fixed rate. I’m a beleiver in variables, but I realized that by the time my recent purchase closed, the variable rate would have likely risen 0.75 points, erasing much of the advantage of going variable, when compared to my five year fixed. A friend of mine took a deeply discounted variable and was surprised to realize that by the time of his first mortgage payment the rate had risen due to BOC action. It all depends on your situation.

  10. In March BMO gave me a capped fixed rate of 2.90% for a 3 year term. My first payment will be in September. It’s possible to get a 5 year variable P-0.75% now but if BOC hikes rate on Sept 8th then my rate would be 2.25% after discount. I am torn between these 2 options. Is 3 year 2.9% a good rate comparing to variable?

  11. Rob,
    How can you side with variables if big bank economists predict 4.50% prime within 2 years?
    a 5 year fixed is available at 4.19%.. so that’s 2 out of 5 years in savings going variable, but what about the remaining 3 years left in the 5 year term?
    I don’t understand the logic?
    john

  12. Hi John,
    Thanks for the note. It’s a fair question.
    First off, the fixed vs. variable decision is environment- and client-specific. So the optimal term will differ depending on the circumstances.
    Our preference for variable over fixed is based on the long-term performance of each and the probability of a low-growth/low-inflation economy. That doesn’t mean a variable is always our choice, and by no means does it imply variables are the best path for every client.
    If you’re in the market for a mortgage then it wouldn’t hurt to speak with a professional that can show you the numbers. Any good mortgage planner can run an amortization simulation that compares fixed and variable terms. Even if prime goes to 5% you can make a case for variable rates being cheaper over five years.
    In the last year we’ve written a few different stories that illustrate this comparison.
    Here’s one: Variable & Fixed Mortgage Costs (Keep in mind, the assumptions change frequently based on current rates and analyst projections.)
    Cheers,
    Rob

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