Fixed, Variable, or Both?

Variable-or-fixed-mortgageWho can be blamed for thinking mortgage rates will stay in the basement for the foreseeable future? We’re witnessing:

That has many wondering why on earth anyone would take a fixed mortgage rate.

Indeed, noted CIBC economist Benjamin Tal says: “We know the five-year (fixed) rate is attractive, but we also know short-term rates are not raising.”

Despite the economic negatives, however, the rate choice is not clear cut. Prime rate could theoretically remain as-is for a year and a half (i.e., until near the expiry of the Fed’s conditional pledge) and then jump 150+ basis points. In that scenario, a four-year fixed near 3% could cost less than a variable over four years, other things being equal.

In the end, most people’s fixed/variable decision boils down to how much they want to pay (or need to pay) a lender for borrowing cost certainty.

Variable rates are roughly prime – 0.70% on the street at the moment. That’s 69-79 bps cheaper than a good 4-year fixed (arguably the best fixed term at the moment). At the outset, that variable rate would save you $37/month per $100,000 of mortgage.

mortgage-riskYour financial breathing room will largely determine if this upfront savings is enough to gamble that rates stay low after 18 months or so. If you don’t want to bet all your chips you can always consider a hybrid (i.e., a mortgage split into fixed-rate and variable-rate portions).

Professor Moshe Milevsky, Canada’s best known mortgage researcher, recently told FP: “I still don’t get why more Canadians don’t split their mortgage.”

Milevsky is a noted proponent of hybrid mortgages, for two reasons: 1) people have no clue where rates will go; and, 2) rate diversification offers the same benefits as investment diversification.

If you’re interested in a hybrid, the most competitive nationally-available hybrids in Canada are currently from Merix Financial, National Bank, RBC, and Scotiabank.

Rob McLister, CMT

  1. Which would make me pay less interest over 5 years (based on current forecasts, i.e. a 150bps jump around 2 yrs from now): 5 yr fixed at 3.39 or 5 yr variable at Prime – 0.75?

  2. I’d be curious to know if there is an online calculator for these types of calculations. Any mortgage calculator I’ve ever seen assumes a constant rate for the mortgage term, not one that gradually increases x basis points over the life of the term.

  3. It’s anecdotal, but my mortgage broker was against hybrid mortgages for the majority of her clients.
    Her rationale was that unless you have a very large mortgage (500$k plus) the savings are mininmal, and those with the means and the stomach for variable rate mortgages lose money from the fixed portion. In her experience the risk averse that take hybrids often end up locking-in the variable portion of the mortgage partway through the term, at higher rates than they would have garnered had they locked in at a fully fixed rate at the start of their mortgage. So in her mind, it was lose-lose.
    It’d be interesting to see if there are stats on how many hybrids get converted part way through the term.

  4. Rob,
    This is a fantastic article outlining the current mortgage market and determining costs associated with going with a Variable vs. Fixed mortgage rate.
    I am leaning towards being a proponent of Hybrid mortgages as well. With the current market uncertainty, it just makes common sense.
    Joe Bladek

  5. Here’s another, but for Canadian mortgages:
    You can tweak it pretty much however you want. We used it to run simulations comparing fixed and variable back in April 2010, and ended up going with a hybrid 50% fixed/50% variable with RBC. Hindsight being 20-20, we should have done 100% variable, but it was very hard to ignore the “rates are rising” hyperbole from everyone, especially from one of the brokers we contacted.

  6. “Prime rate could theoretically remain as-is for a year and a half (i.e., until near the expiry of the Fed’s conditional pledge) and then jump 150+ basis points. In that scenario, a four-year fixed near 3% could cost less than a variable over four years, other things being equal.”
    The best way one can insure themselves in that case is taking a variable rate mortgage while keeping the payment amount at a level of a 5-year discounted fixed. This way you pay off more of the mortgage while rates are low and build enough of a cushion for when prime may potentially rise.
    The key is finding a flexible exit plan if rates rise past the borrower’s risk tolerance. Most variable rate mortgages provide the option to convert to a fixed rate during the term at no cost (it should be noted that some lenders have time limitations). Thank you very much. But what will be the fixed rate upon conversion? Banks never guarantee the fixed rate in writing. I think the only major bank that offers some kind of guarantee is Scotia with posted rate minus 1%. The problem is that posted – 1% is almost never the lowest rate in the marketplace. This is where brokers can really differentiate themselves because we work with lenders that guarantee the lowest discounted fixed rate upon conversion in writing with the current mortgage commitment.
    As for hybrid mortgages, you have to do the math carefully to see if it’s really worth splitting the principal like that. Lenders that offer hybrid mortgages tend to market them as a one size fits all solution. But there’s a lot more to it than simply mitigating interest rate risk.

  7. Hi Lior,
    Thanks as always for the post. Our rate simulations assume the client will pay his/her variable like a fixed. In this scenario, the 4yr at 2.99% was still theoretically cheaper than a prime – 0.70% VRM, other things being equal.
    Naturally, this considers only the pure rate math because there’s too many borrower-specific scenarios to factor in. Therefore people should always run their circumstances by a mortgage professional before relying on hypotheticals.
    You raise an excellent point about conversion rates. There will be a separate story on that topic this week.

  8. Hi Jeff,
    Many thanks for the posting.
    Your broker is right that hybrids are not a product for the majority. But the minority is still a lot of people.
    The savings of a hybrid can’t be deemed “minimal” today because the savings is totally dependent on future rates. In addition, “minimal” is relative to the borrower. Saving $1,000 could be minimal to person A but significant to person B.
    Hybrids are basically a form of diversification. Every investor knows that you can make more money being 100% in stocks long-term instead of 50% in stocks and 50% in bonds. But people still add bonds to their portfolio to smooth out the risk.
    It’s the same thing with a hybrid mortgage. You would have done better being 100% in variable over the years, but not everyone is suited to a 100% variable rate.
    Folks often forget that discounted fixed rates have beat variable rates 23% of the time (assuming you use Milevsky’s latest academic research). That’s almost 1 out of 4 times. While our current economic reality suggests rates aren’t going up for several quarters, no one can rely on that with certainty. We’re in the trough of a cyclical economy and economic prospects can change completely in 6-12 months.
    The conversion issue is a separate but valid topic, and one we’ll touch on this week.

  9. First of all – it has been proven that variable rates beat closed mortgage rates most of the time. So why even discuss it if you have a large mortgage? Go variable.
    Economy can not possibly improve in the next 3-5years to varant significant rate increase. Look at Europe – they are sinking and there are no life jackets on the horizon. Not good, it’s getting worse by the day, and it’ll take years to repair the damage and get the economy into positive teritory.
    BTW – Scotia offers 5yr variable at prime-0.7% I was told today, and 3,4 or 5yr closed are all at 3.59%. Yes it is all confusing what to do, but the more you agonize the worst decision you’ll make. I don’t have a cristal ball but I listen to people who have been through this before. I wish a listened when they said never to buy stocks or mutual funds, and instead buy land or real estate (novel idea, ha?).

  10. Signed for a variable tonight – Ill evaluate where I am in a year, for now unless there is a currency meltdown, I anticipate rates will flatline till this time next year

  11. “Economy can not possibly improve in the next 3-5 years”
    As soon as I saw that line I stopped reading. Anyone who uses “cannot possibly” in the same sentence as “economy” has never studied economic history and is doomed to repeat it.

  12. Great Site. I don’t think there is a better source for complete discussion on mortgage related issues. Please keep it coming.
    I am sitting at prime -.7 variable closed….with 4.5 years left This was offered to me to change from a prime -.3 variable open. The bank was afraid I was going to leave them.
    We are also paying as if we were fixed at 5%. We are trying to get ahead in the case we get caught benind if the rates move.
    I am watching, reading and learning….Thanks so much to all who comment here. It really does help.

  13. Hybrid is just another form of hedging. As with all kinds of hedging activities, there could be administrative overhead (i.e. hidden cost) associated. One has to be very careful about the those hidden costs, such as mortgage discharge fee etc. There is no free lunch …

  14. I have recommended this to many clients who are undecided…why not pay your lower rate variable as though you’re paying a higher rate fixed, making significant progress in paying the principal early on. It’s again just another way to hedge.
    Based on current conditions I am still in favour of Variable, but we do offer a great hybrid product that offers the best of both worlds, and has a credit line tied in.

  15. Indeed. And yay for the post on conversion rates! I’m quite surprised at the number of people out there aren’t aware of this. I mean, if I take a variable mortgage today and at some point in the future I want to convert it to a fixed rate because rates have increased past my comfort level, what kind of assurance I have that I’ll get the lowest rate upon conversion? If I can have something in writing now that says I’ll get the lender’s lowest fixed rate (no “come and talk to us” b.s.), that’s a huge value proposition.

  16. I work at TD and many of our customers are looking for direction on which way to go. We are seeing quite a few take the variable interest rate mortgage, but, as always, we’re advising people to choose their mortgage terms carefully because deciding between a variable rate or a fixed interest rate mortgage depends on a person’s comfort with interest rate risk and their ability to carry a higher mortgage payment if interest rates rise on renewal. Also, because the qualifying rate for variable rate insured mortgages is the prescribed Bank of Canada Rate (which is the 5yr posted rate) some buyers who wish to take a short term or variable interest rate mortgages may not qualify due to their debt service ratio.

  17. I just got prime -.8% by talking to my mortgage specialist and telling her I knew that was the best they were offering.
    No Broker Required.

  18. I just got prime – 0.81%.
    I win. You lose.
    If you find better than I will find better to beat you, because rate is all that matters right??

  19. Please enlighten us on how you knew what the “Banks best offering were when Banks never advertise or inform consumers of their best unpublished rates?
    Instead of “No Broker Required” you should have closed with “I waste broker’s time by ultimately rewarding my Bank with my business”
    Rest assured, while your gloating online about screwing independent brokers out of your business, we the Banks are working hard and spending BILLIONS” on elaborate computer systems tracking your spending habit’s so that we ultimately squeeze every last $ from you!

  20. Why limit yourself to one bank when a mortgage advisor can help you compare every lender in Canada?
    You don’t call up one airline to book a flight. You use a site like Expedia or Kayak to compare the fares/restrictions of every airline.
    A broker works the same way but you get to speak with an actual person and form a relationship. In my experience brokers help people find a better mortgage at the same or better rate 9 times out of 10. The best part is, there is no cost to the home owner!

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