Will we ever stop writing about which rate is better: fixed or variable?
And the answer will probably always be: “It depends.”
Yesterday, Rob Carrick from the Globe & Mail ran this story on why variable-rate mortgages should not be written off. Its main arguments are that rate risk has declined and historical studies support variable rates.
Well, in our books, Carrick is one of the best tell-it-like-it-is writers in personal finance. But this particular story needs at least a teaspoon of perspective.
The premise of the article is that variable-rate mortgages are worth a second look, for the following reasons:
1) Because rates won’t rise much
David Larock, a good broker and an equally good blogger, is quoted as saying “(Will rates rise anytime soon?) I just don’t see it, no.”
But there lies a problem. Apart from the very short term, we all know rates are entirely unpredictable. When the Bank of Canada (with its virtually unlimited resources) cannot consistently forecast economic activity, we as laypeople and brokers have absolutely and unequivocally zero chance of doing so.
The economy surprises analysts almost every single year.1 There’s always something we didn’t foresee that moves interest rates in ways we didn’t predict. Yet, because we’re emotional creatures who overestimate our own abilities, we insist on forming rate opinions (and those opinions are invariably either too optimistic or too pessimistic).
The point is, while our gut may point to low rates for longer, we don’t know:
for how long, and
how the timing of future rate changes will coincide with our mortgage renewal date(s).
Even if we expect only a few BoC hikes, it wouldn’t take much of a jump for fixed rates to prove cheaper. Just a modest rate increase (e.g., 0.75 of percentage point in 2015 and nothing more) could a make today’s 2.99% five-year fixed less costly than a prime – 0.40% variable-rate.2
Note: A 75 basis point increase to prime rate would still put us 35 bpsbelow the 10-year average (not that averages have significant predictive power).
2) Because variable rates have won in the past
The story cites a statistic (presumably from Moshe Milevsky’s research) that variable-rate mortgages have been cheaper 90% of the time.
That stat is easily the most misinterpreted statistic in the mortgage business. The actual research shows that assumptions are everything. (Here’s more on that: Fixed/Variable Research)
In brief, that 90% figure is based on an environment that no longer exists, one of posted rates and a long-term rate-downtrend.
Milevsky found that a simulation based on discounted mortgage rates (instead of posted) makes fixed mortgages come out on top roughly one-quarter of the time.
And, if you wanted to take it a step further, you could backtest rates using today’s tiny 39 basis point fixed-variable spread. If you did that, you’d quickly see that the fixed vs. variable decision becomes a statistical toss-up.
The takeaway here is that it’s a tad early to declare “variable-rate mortgages are back.”
For most people, especially younger borrowers, going variable today is like betting on red or black. You’ve got to pick your gambles in life and, for new mortgages, the variable-rate odds simply aren’t enough in your favour.
Of course, rates could theoretically fall from here (or go sideways for years) and make floating rates a winner. But that wouldn’t mean that variable rates are the right choice based on the information we have today.
If you do need a short-term mortgage, go with a 1-year fixed instead. They’re cheaper upfront, more flexible and a 1-year potentially lets you renew into a variable rate with a deeper discount.
1 The Citigroup Economic Surprise Index compares analyst expectations to actual economic readings. It shows how often the pros over- and under-estimate economic activity—and in turn, interest rates.
2 This analysis measures interest cost only and assumes: (a) a 25-year amortization, and (b) that the variable- and fixed-rate mortgage payments are made equal (this compares cash flows on an apples-to-apples basis).
Monthly interest isn’t the only determinant of borrowing cost. Fees, penalties, amortization and a slew of other factors must also be considered. That’s why telling everyone to lock in is like telling everyone to buy bonds instead of stocks. It’s not appropriate since personal circumstances affect suitability.
If, for example, you’re quite financially stable and already in a deeply discounted variable (like prime – 0.80%), you’re likely better off riding it out. (Here are some additional fixed vs. variable suitability criteria.)
For the reasons above, the fixed-rate commentary in this post is primarily aimed at people who are:
suited to either a fixed or variable mortgage
getting a new mortgage (as opposed to someone in an existing variable rate)
unlikely to make significant mortgage changes in the next five years.
Many people don’t meet these criteria. For those folks, a competent mortgage professional can provide the best feedback on term selection.