The Incredibly Shrinking Variable Discount

Shrinking-Variable-Rate-Mortgage-DiscountsJust weeks ago you could find variable-rate mortgages at prime – 0.80% (P-.80%) or better. Consumers thought they were here to stay, but the tables turned…fast.

Economic troubles and lender profit motives have shrunken variable discounts beyond expectations. Banks are now commonly quoting prime rate, for example, with little discounting.

Once the last few holdout lenders with P-.50% disappear, discounted variables could move towards P-.25%…or worse. Some lenders even suggest that prime or prime plus could be the new normal.

Meanwhile, aggressive brokers are selling five-year fixed rates at 3.25% or less. That’s an unusually low 50 basis point premium to a variable. A spread that tight doesn’t come around often, and it makes you rethink all of the research suggesting variables are the way to go.

Popular research indicates that people have saved money on variable-rate mortgages:

Odds like that make some people question the sanity of going fixed.

But there’s a little more to the story.

Economic-crisisWhile variables have cost less than 5-year fixed mortgages a majority of the time in the past, favourites don’t win every game.

More importantly, assumptions are key when it comes to rate studies. Two important factors have impacted the research quoted above:

  1. A multi-decade bias towards falling rates
  2. Use of posted rates (instead of discount rates)

“Interest rates have been trending downward for two decades,” BMO Capital Markets Senior Economist Benjamin Reitzes told us in a recent interview. By default, he says, that’s tilted the table more in favour of variables than it otherwise would be.

Looking ahead, rates are no longer able to drop over one percent. The most we can realistically hope for is an extended period of horizontal rate movement. (The BoC can still cut rates slightly, but the European and American crises and sub-2% core inflation won’t delay hikes forever.)

As a result, Reitzes says, “Going forward, borrowers won’t see the same advantage to variable rates as they have in the past 25 years”

The second factor that’s largely ignored when citing rate research is the actual mortgage rates used for backtesting. Each of the three studies above uses posted rates in their historical analysis.

Reitzes states that this practice distorts the results somewhat. “Discounts off posted rates were not as prevalent historically.” Nowadays, however, “Most people get a (rate) discount if they are credit-worthy borrowers.”

That matters, because the rate discount you get obviously impacts the likelihood of your mortgage outperforming other options.

Here’s an example.

  • If you look at data from 1970 to 1995, the average difference (spread) between 5-year fixed and variable rates was 126 basis points.*
  • The average difference today is roughly 50 basis points.

That’s a remarkable 76 basis points lower than historical rate spreads. That makes a huge difference in research conclusions.

If you theoretically backtested with the same spreads as today (i.e., 25 bps off prime for variables and 204 bps off posted for 5-year fixeds), you’d find that fixed rates outperform considerably more often.

According to Milevsky, “…The historical probability of doing better with the floating rate mortgage…hovered around 70% to 80%” when the borrower used deep discount rates (based on a 1965-2000 study period).

Using today’s discounts, that 70-80% drops to just 53%, based on our findings from 1970 to 2006. (Obviously today’s spreads would not have applied historically but, as Milevsky maintained in his research above, that is beside the point.)

In other words, the fixed/variable decision would have been a coinflip, based on today’s spreads.


(Click to enlarge)

This isn’t meant to imply that fixed rates now have an insurmountable edge. If the Bank of Canada drops rates unexpectedly, a variable could easily beat all other terms over the next five years.

A variable may also prevail for other reasons. See:

That said, if the BoC’s next rate move is up (which is the highest probability outcome, say economists), the boring old 5-year fixed could certainly outperform. That’s true even when compared to a variable with payments set at the 5-year fixed rate. (We’ll post a scenario like this soon.)

The nice part is this: If you go fixed and variables end up winning, you’ll likely be out far less money than in most prior years.

* Data source: Bank of Canada. (We chose 1970-1995 because 1970 is as far back as we have clean 5-year fixed rate data, and 1995 was before rate discounting started taking off. Yes, people actually used to pay posted rates.)

Note: If you’re already in a discounted variable, the conclusions drawn here may not apply to you. For guidance on locking in, always consult a mortgage professional.

Rob McLister, CMT

  1. I’m almost one year into a 5 year varible term at prime minus .70 with First National.
    I see that they dropped the discount last week & are only offering prime for their variable mortgages now. I am paying extra each month & plan on keeping the variable for now…

  2. I’m thinking of buying another house in Toronto. Approx 1.5mm purchase price, and I can pay 20-30% up front. Problem is that I have four mortgages already (mostly income properties, with flat to positive carry). Balances on those are between 25%-75% (average LTV less than 50%) Traditionally I’ve dealt with bank representatives only.. would a broker be able to help me on this? Oh forgot to mention, salary income (pre-tax) last year is about 600-700k.

  3. Broker can do sometimes a bit more than a bank will do in their normal channels. But with so many mortgages and mentioned purchase price I am really surprised you haven’t contacted one yet …

  4. Excellent article, I hadn’t factored in the significance of the shrinking rates over the period of the studies previously.

  5. Many of the Monoline lenders (including Macquarie) who’s fiscal years generally start earlier then the banks had been saying that the variable discounts where not profitable under the new IFRS accounting rules and that things could change once everyone in the industry had to follow those rules. The banks fiscal years are just changing over and they have to also start on the IFRS rules now and it is making a difference in the discounts.

  6. What’s happening with variable and fixed rates at the moment is basic economics. Fixed rates are low because investors continue to take shelter in government bonds because of all the uncertainty in Europe, the US, and even Canada which is heavily leveraged to the US economy.
    The 5-year Canada bond yield is currently around 1.50% and it has remained in that range for a few weeks. If anything, a 5-year fixed rate at 3.25% represents an inflated margin even with the increased costs associated with the conversion to IFRS.
    Variable rates have increased because the cost of funds for lenders have increased. The international banking system is tightly linked and there’s heightened volatility in the credit markets because of the exposure of European banks to sovereign bonds of peripheral Eurozone members. The TED spread, for example, which is one of the leading indicators of volatility in the credit markets, is at a one-year high and has more than doubled since early August. While it is nowhere near the record high reached in October 2008 at the peak of the financial meltdown, the fact that there has been a noticeable increase over just a few short weeks is indicative of the contagion in Europe spreading into the international banking system.
    As far as mortgages go, my advice is keep a steady hand rather than jump on the flavour of the moment. The banks are doing everything in their power to get consumers onto the fixed rate bandwagon with short-term teaser rates. But statistically, variable rates have almost always paid off the mortgage quicker and with less interest going to the lender.
    So if you happen to be conservative with your finances and you’ve always locked your mortgage with a fixed rate, today’s 5-year rates are the lowest they have ever been and consumers should take full advantage of these unusually low rates to consolidate higher interest debt and prepay their mortgage.
    But keep in mind that a fixed rate, especially the very popular 5-year term as low as it is these days, comes with a significant premium and not just rate wise. Should interest rates increase during the term, you’re potentially looking at a significant IRD to discharge your mortgage before the term matures. Moreover, some lenders who offer promotional rates require a bona fide of the property to discharge the mortgage. If you plan on locking in with a fixed rate or any “low rate” teasers, make sure you stay in the same place until the term matures (this also includes having an emergency fund to make the payments if you lose your work or your income is reduced as the economy slows down, tenants lose their work and can’t pa rent, etc. etc.) Basically, during times of economic volatility, hope for the best but prepare for the worst. Otherwise, the savings realized from the slightly lower rate would evaporate very quickly once the penalties are tackled on.
    Don’t just look at the fact that variable mortgages are now priced at prime. Looking at history this trend tends to be temporary. If you have traditionally opted for a variable rate mortgage, I would just stay the course and ride out the volatility.

  7. Lior
    I like most of what you have said, but question “if rates go up, you will be in to significant IRD charges”.
    IRD charges increase when the then current rate drops below my charge rate, so the likely penalty, going forward with higher rates ( over my captured charge rate would likely be 3 months interest, as their would be no “loss” of interest to the lender on reinvesting my monies

  8. Great article. I own several investment properties and when choosing a mortgage I always consider the spread between fixed and variable. I got my last mortgage at a time where the prime rate would have to double before I would start to lose with the variable rate. It simply didn’t make sense to go fixed.

  9. Great work Rob – another very insightful and useful piece. While no piece of financial research is ever without its limitations, this is one of the more thorough and broadly applicable pieces I have seen relating to mortgages for some time.
    I have been a long term advocate of short term and variable rate mortgages since Moshe conducted his research, but the product is not for everyone. Factually they were designed for those who can financially and psychologically endure interest rate market fluctuations (which most can’t do).
    Many mortgage consumers today couldn’t afford their mortgage payments if rates went back to historical averages. This thoughtful analysis should help us mortgage professionals show them this.
    Thanks for pulling this together Rob!

  10. Im happy with my prime -0.75
    I plan on staying there as Id have to go through 6% prime before I lose on this bad boy and I dont see Prime going to 6% in the next 2-5……hundred years!!!

  11. Thanks for the advice! Seller is being greedy in what feels like a chillier market (listings exploding, inventory not moving etc). Just wanted to be ready in case something gets done (dangling a no-condition bid, so don’t want to lose my deposit).

  12. Hi Lior,
    Thanks for the post.
    One quick thought regarding:
    “statistically, variable rates have almost always paid off the mortgage quicker and with less interest going to the lender.”
    I try to be careful when quoting past rate studies, for the exact two reasons mentioned above. The impact of falling long-term rates and the difference in today’s fixed-variable spread cannot be stressed enough. Any way it’s sliced, variables are less attractive today than they have been in the past.
    On the other hand, there’s still a place for VRMs based on the client and situation.
    As a reminder in general, this article applies more to people who are shopping for a new mortgage than to people considering locking in.

  13. Key words to be found in this article is “..lender profit motives…” But do not be fooled into thinking the banks are not profiting. Just not profiting enough. However, the company I’m most familiar with are far as deals are concerned is ‘Firstline Mortgages’. They’ve cut back on the incentives available for the mortgage broker to pass onto the client as far as rate is concerned and the days of P minus 0.75% or 0.80% are indeed gone. The broker in question would have to dig deep into their “points” pocket to offer up a competitive rate, but most likely will send it elsewhere; and to a shop that hasn’t cut back just yet. Can anyone say oligopoly? Especially, once those points have been spent. What’ll happen when they start cross selling and poaching their clients. The days of the mortgage broker are slowly coming to an end too.

  14. Hi Shiraz,
    How many “investment properties” do you have mortgages on? Is there a limit on the number of mortgages one can hold? As mentioned I have four already and thinking of #5 (total balance on the first four is less than 3x current pre-tax wage income, and total aggregate loan to value is less than 50%). Thanks to this forum 3 of the 4 are floating rate :)
    One bank I went to said this may be difficult. I have never worked with brokers before. How should I start this process (e.g. preapproval, rate lock, etc.)?

  15. Hi
    I have 4 properties and have a variety of mortgages on them. Some are variable, some fixed and one is a HELOC with a fixed/variable mix.
    I will generally go for fixed if I can get a 5 year fixed rate under 3.50. Having seen friends who have added 5 years on to their amortization by going variable and the rate increasing I don’t want that happening to me.

  16. Hi PC, are your properties residential or commercial? Traditionally most banks and non bank lenders do not like to finance more than 4 residential properties (1 to 4 units). Some lenders will finance 4 by themselves and some lenders will only do up to 4 including other lenders. On commercial properties it is unlimited. You should still be fine though. National Bank for example will finance up to 16 doors residential but they include units in this figure so 1 property with 4 units is considered 4 doors. If you need more information I will be glad to help, email me at or call me at 416 899-1467. Cheers Robert

  17. Hi there, I currently have a Prime – 0.9 Rate and can get a 4 yr 2.89 Fixed Rate. In your opinion, do i switch or remain with my Current Rate. I am also overpaying to take advantage of my current Rate

  18. Hi SID,
    Thanks for the note. That’s why I said “potentially” because if a homeowner is assessed an IRD it is based on several factors like the amount of time remaining on the term as well as whether the lender rounds the term up or down, if it’s based on posted or discounted rates, etc.

  19. PC I would be very interested in talking to you about your options. I don’t see convincing the bank to take your mortgage app request as difficult.

  20. I don’t share your doom and gloom assessment of the mortgage broker industry. There will always be room for brokers that maintain their independence and serve their client`s well.
    Like any industry, you have to know your strength’s, create a market leading niche and exploit them for you and your clients mutual benefit. A broker undercutting the market and offering the lowest rate will never make it long term because ultimately, any banker can authorize any rate they willingly choose, anytime.

  21. Variable versus fixed still simply comes down to this: do you want to face the risk of your rates going up in the future? Yes the variable is still lower than fixed, but the low prime makes it even more probable the majority of variable loans will see an increase at some point.
    With the instability of the ecconomy, the overall rates on variables has seen a slight increase already, making it a less appealing option for those buying a home they plan on holding onto for some time.

  22. The mortgage industry has blindly used Milevsky’s findings to advise people for years. It’s good to finally see some common sense in interpreting and applying his research.

  23. Re: “The days of the mortgage broker are slowly coming to an end”
    Thanks for the comment.
    Further to Banker’s post (which is spot on), there are certainly brokers who refuse to adapt to the new rate market and time-pressed Internet-savvy consumer. Natural selection will take those brokers out of the game in time.
    But there are many others that are on the leading edge in terms of technology, mortgage planning techniques and efficient service. At the end of the day this is still an advice and service business and that will never change. The only question is: How will clients choose to receive this advice and service. What happens in the next few years may surprise many in our industry.

  24. You are in doubt … you want to have the lowest rate (Prime minus .9) but you want security too.
    The best solution for you is to split your mortgage – 50% stays on prime minus .9, 50% fixed on 4yr term

  25. Do you people think Prime is going past 6%?
    Im betting it wont in the next 2-5 years.
    Ill enjoy my variable at my discount for now.

  26. Prime 6% ? Maybe in 3-4 years (if the inflation goes rogue), but not in 2 years for sure.
    Remember : US economy dictates our economy at this time.

  27. Agreed, not in two years for sure.
    If I need too, I can change to fixed but again – it would have to go North of 6% prime for me to lose money overall.
    For now I sit and relax while my consolidated debt gets paid down.
    I wont be making the same mistake twice of taking out a Home Equity Line of Credit.

  28. I send clients to a variable rate of anywhere between 1.75 – 2%… the 5 year rate is still quite a way off….you also have to remember that the interest differential in terms of pure dollars out of your pocket really becomes a lot more significant when they are starting to jump over the 5% range….don’t see that happening for a long time……And when higher interest rates return (and they always do) smart mortgage holders will have paid down a nice bit of principal with these low rates…..just because you have a low rate does not mean you have to have a low payment…..

  29. My favorite line of the posting is ‘ almost boils down to a coin toss ‘ . I agree.
    Perhaps, should be mentioned again, the VRM is only for BoC qualified at 5.19% customers.

  30. PC skip the broker route go to Mobile Mortgage rep from TD, RBC they will blow the doors off any broker rate, not to mention setup someone with your calibre of income, portfolio other benefits that no broker would even come close to. Also the hidden gem is HSBC they don’t have any MMS reps, they killed there broker program year or so ago, very , very aggressive lender in the way of rates, close friend of mine got a Prime minus 1% HELOC about a month ago. yes thats 2%. I didn’t believe it till i called HSBC & its true. totally depends on your portfolio.

  31. Could you possibly lie any more?
    I’m seeing RBC mortgage specialists quoting discretionary rates of 3.59% for a 5 year fixed and prime – 0.20% for variable. Brokers can beat both of those rates by a quarter point or more.
    There should be a thumbs down feature on this site to rate imbecilic posts like yours.

  32. stop bragging about your financial successes, you know more about mortgages than most it sounds like, so come down to earth with the rest of us who are dealing with one mortgage and want the best advise.

  33. Both variable and fixed are low and I think that they will remain low for two to 4 years. How low? It doesn’t matter, just pay as much off as you can monthly and add extra payments whenever extra money becomes available. Does anyone really believe that rates can go anywhere soon?
    If they go up, Canadian home owners will suffer and home prices will fall.
    If they go down, the bank profits will suffer.
    Neither is good for the economy and Flaherty knows it. So the rates are all stuck between a rock and a hard place. Consumers win!!! Enjoy and pay your $#1% off.

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