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Fixed/Variable Rate Scenario

Rate scenario spreadsheets are a handy tool in a mortgage planner’s tool chest. Advisors use them frequently to illustrate hypothetical cost differences between different mortgage options.

One common scenario is the 5-year fixed vs. 5-year variable comparison. We ran a showdown on these two terms when writing Monday’s story. (Click the chart below to enlarge it.) - Scenario

The comparison above shows a prime – 0.25% variable versus a 3.25% five year fixed. It assumes three (and only three) quarter-point BoC rate hikes, starting in March 2013.

Background: With economists projecting rate hikes by year-end 2012, this scenario’s assumption of higher rates by 2013 is reasonable. The reason we chose only three rate increases for the assumptions is simply to determine the minimum hikes needed to make the fixed mortgage cheaper than the variable.

Mortgage-SimulationThe purpose of scenarios like this isn’t to forecast rates or express exact borrowing costs, but rather to show what could happen (approximately) if reasonable assumptions pan out.

Note: Many other factors impact total borrowing cost besides rate, including but not limited to prepayments, locking in and penalties (for breaking a mortgage early). Those aspects can also be estimated and factored into scenarios. Here, we’ve assumed the variable-rate borrower has no need to break the mortgage early, and will initially match the fixed-rate payments (for an apples-to-apples comparison of monthly cash flows).

Once you visualize the potential cost difference between a fixed and variable mortgage, you can then decide if the fixed rate is worth the extra upfront premium.

In this particular case, the 3.25% five-year fixed just edges out the variable on paper (it is hypothetically $11 cheaper than the variable over five years). Again, this is based solely on the sample interest rate assumptions, which presuppose a small rate tightening campaign starting in spring 2013. Naturally, any additional rate hikes would increase the advantage of the fixed rate.

The objective here is mostly to reiterate what was said Monday. Today’s five-year fixed rates are surprisingly competitive thanks to lenders getting stingy on variable-rate discounts.

Talk to your mortgage planner and have him/her run some scenarios that match your own circumstances and outlook. You might even find that other terms project out cheaper, such as the 2.99% four-year fixed.

Sidebar:  As noted Monday, there’s still an outside possibility of a BoC rate cut by next year. If that happens, variables would likely outperform all other terms, even with today’s mediocre prime – 0.25% average discount.

Analytical types will assign a probability of those rate cuts occurring and then weigh all the different scenarios to reach an “expected value” of the fixed/variable cost difference.

Rob McLister, CMT