Mortgage debt

Mortgage debt (Photo credit: Wikipedia)

With recent bank promotions of 2.99% fixed for four years (some even for five years!), there have been a lot of discussions on whether it’s a better deal to go for a fixed-rate or not. What do you think? Better to go for a fixed-rate, or a variable-rate? In this post, I’ll compare both scenarios, and take a look at what happens should interest rates rise.

What if I’m looking to get a new mortgage?

Well, if you have a choice between a 3% variable-rate mortgage, and a 3% fixed-rate mortgage, I think that taking the fixed-rate mortgage is a no-brainer. The same rate, but with less risk! No need to read on if you are in that situation.

What if I already have a variable-rate mortgage, and I’m thinking about refinancing?

This situation gets a little bit trickier. In our case, we took a variable-rate mortgage a year ago back when the discounts on prime were still in effect, so we’re paying 2.30% on a 5-year variable. We have four more years to go before it’s time to renew into another mortgage, and another rate. When we were looking for a mortgage, premiums on the fixed rate were a little bit ridiculous; the situation has changed and now you can get a fixed-rate at 2.99%! Is it worth it?

Let’s analyze the following scenario:

  • $250,000 mortgage.
  • Variable-rate mortgage @ 2.30%.
  • Fixed-rate mortgage @ 2.99%.
  • Mortgage is up for renewal in 4 years from now.
  • 25 year amortization.
  • Monthly payments.
  • Bi-annual compounding.
  • Figures start at period 1 (though choice of period does not alter the relative differences very much).

Our calculations will be done using the Canadian mortgage style. For the curious, here is how you calculate a Canadian mortgage in your spreadsheet:
Payment = PMT((1 + RATE/2)^(2/12) - 1, NUM_PERIODS, -MORTGAGE_AMOUNT, 0, 0)
Interest portion = IPMT((1 + RATE/2)^(2/12) - 1, THIS_PERIOD, NUM_PERIODS, -MORTGAGE_AMOUNT, 0, 0)

This is for a mortgage that is paid monthly, but is compounded bi-annually as is the standard for a Canadian mortgage.

First, let’s look at the scenario where rates do not change for the next four years:

Variable – Baseline @ 2.30% Fixed @ 2.99%
Monthly payment $1,095 $1,182
Interest paid $21,520 $28,082
Chart of variable mortgage @ 2.30% versus a fixed rate mortgage @ 2.99%, 4 years, interest payments.

Our monthly payment for a variable-rate mortgage will be $1,095/month, while for the fixed-rate mortgage it will be $1,182/month. Not a big difference, but things get more interesting when we look at the total interest paid. By sticking with a variable-rate mortgage, if rates don’t rise at all, we will save $6,562 in interest payments.

Wait a second… are you really expecting that rates will stay at the same level for the next four years!?

It’s always possible, but maybe it’s not that likely. Let’s look at another possible scenario: Rates rise by 50 basis points per year, so that by four years out we’re ending at a variable mortgage rate of 4.05%, with a prime rate at 4.75%. How would things look, then?

Variable – Increasing @ 0.5%/year Fixed @ 2.99%
Monthly payment $1095 – $1322 $1,182
Interest paid $29,748 $28,082
Chart of variable mortgage @ 2.30% versus a fixed rate mortgage @ 2.99%, 4 years, interest payments. Variable rates increase by 50 basis points per year

The two mortgages are much closer to each other! In the face of rising interest rates, the variable mortgage starts to fall behind the fixed-rate in terms of total interest costs. (Note: My original post had it slightly in favour of the variable-rate mortgage, as I had interest rates increasing every 8 months instead of every 6. Thanks to Mr. Math for pointing that out).

What about if rates rise even faster than that?

I find this scenario no more likely than the scenario of rates staying at the exact same place for the next four years, but let’s say that the prime rate increases by a full 100 basis points per year. This would end the variable mortgage rate at 6.05% by four years out, with the prime rate at 6.75%. If we were renewing, we could expect fixed-rate mortgages to be in the 8% to 9% range by this time.

If there was a good chance of rates being that high, banks would be taking on a pretty big risk by loaning cheap mortgages. The value of those mortgages could be expected to fall substantially. Then again, the banks could all be wrong; it’s happened before.

With rapidly rising interest rates, the variable-rate mortgage no longer looks so attractive:

Variable – Increasing @ 1%/year Fixed @ 2.99%
Monthly payment $1095 – $1607 $1,182
Interest paid $39,314 $28,082
Chart of variable mortgage @ 2.30% versus a fixed rate mortgage @ 2.99%, 4 years, interest payments. Variable rates increase by 100 basis points per year

Things are starting to get painful for the variable-rate mortgage holder. They’ll definitely be better off in a fixed-rate mortgage if rates climb this much over the next 4 years.

I haven’t touched on penalty fees, time spent meeting with mortgage brokers, etc… so all of those factors must also be considered before you decide to refinance.

Dear reader, what about you? Have you decided to refinance lately? What are your thoughts on the current interest-rate environment?

Read more about Canadian mortgage trends here: Canadian mortgage trends.

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Kevin has left the office, and he is currently fighting the rat race by working on his own business. He enjoys exploring unvisited places around the world and gaining new experiences. He believes that by properly managing our energy and time, we can learn to invest our lives wisely.

38 Comments Kevin on Apr 16th 2012

38 Responses to “Should I Convert My Variable Rate Mortgage to a Fixed Rate Mortgage?”

  1. Here’s another interesting scenario: take a 50/50 var/fixed split mortgage to lessen the risk and still profit from var rates. One can also lock in the var rate to fixed at any time if he/she starts feeling uncomfortable with rate hikes. all in all, several ways to profit from historically low rates!

    • Kevin says:

      Hi Mich,

      That might be a good option of hedging against a greater loss should rates rise greater than expected, though at the expense of less gains if they don’t. I wonder though about the costs of converting the mortgage and such. Our mortgage is variable but it’s not open.

  2. At these historically low rates, you’re crazy if don’t lock into a fixed rate mortgage. Mortgage interest rates were in the mid-teens back in early 1980s so it made sense to have a variable rate when interest rates were falling. Now the odds of interest rates increasing are very high. People with variable rate mortgages are due for some unpleasant surprises.

    • Kevin says:

      Hi Biz,

      Keep in mind our time horizon is only 4 years here. If we were talking about 15 years or 30 years, and you’re looking at low rates like this, then I agree, it’s a no-brainer. Also, for someone getting a new mortgage today there’s no point in going variable since the rates are the same. However, if you already have a mortgage, you have to renew in at most 5 years, regardless of whether it’s fixed or variable, so even fixed is not going to save you from increasing interest rates. Another option worth looking at might be the 10-year at 3.99% actually. I think the odds are better that rates will be higher than that in 4-5 years time.

      • Kevin says:

        Though this depends on the bank. Usually more than 5 years is a big rip-off which is why 5 years is the standard here in Canada. For example, TD has their 10-year rate posted at 6.750%.

        • Kevin says:

          And RBC has their 5-year advertised at 5.440%! Haha, the banks are tricky. If you do some shopping around you might be able to get this down to 3.29% or even 2.99%. Anything much higher than 2.99% and I think that variable is still the winner, until renewal time 4-5 years out.

  3. Kevin says:

    I dug up a blog I used to visit regularly when I was in the market for a mortgage:
    You guys might find it useful!

  4. I’d stay variable for sure. Rates aren’t going anywhere!

    • Kevin says:

      Do you think we’re gonna see low rates for the next 10 years? Is it even possible to run into a situation where we have both low rates and high inflation? I think it is, at least on the official domestic markets, if the central bank outbids all other buyers. What do you think? Man does this punish savers, though. :(

  5. Most people will tell you that you should definitely have a fixed-rate mortgage. Considering that the variable rates fluctuate with inflation, you’re always better off going fixed. With variable interest rates, as prices rise, so does your loan interest. With fixed, your loan interest stays the same regardless.

    • Kevin says:

      I definitely agree if you can get a sweet fixed-term over a long period of time. I’m personally more averse to the risk that the variable rates surpasses 3.49% within the next 25 years, rather than that I pay too much interest if it doesn’t. If you can get a rate like this for a long term like that, that is sweet. :)

  6. Good timing. I am in the same boat with a 2.40% variable rate (prime minus 0.60%). I started looking at it the same way. I only have 3.4 years left in my 5 year term though.

    I have also learned historically that short terms always beat taking long terms (there is a reason why 5 year is promoted :)). I am hoping to get pas the 3 year threshold so I can go with a 3-year fixed term if I stick to the same bank. I don’t see a problem since they always match anything I can get.

    As Financial Samurai say, I don’t see rates going up too fast over the next few years but a rate increase by the Bank of Canada is usually done in 0.25 increments so it can add up with a few rate increases.

    For now, I think I’ll stay with variable and review after the first rate increase they do whenever that may be.

    One note on your calculation, I would also make the monthly payment the same and equal to the highest which reduces the amortization on the variable rate – a double win :)

    • Kevin says:

      Thanks for the comment, PIE. I definitely agree — if I’m going to be paying a certain % of my income, then I much rather pay more on the variable and have that reduce the principal faster, rather than be paying the same payment on the fixed.

  7. Sunil from The Extra Money Blog says:

    count in my vote for variable. I agree that rates are not going anywhere . . . but yes the decision is situational to the earlier point made of buying a new home or refinancing over a long term

    • Kevin says:

      For Americans the mortgage rates are lower and the terms longer IIRC? Do you think the Fed will accomodate low rates, even in the face of high inflation?

  8. We currently have a variable mortgage on one house (that’s sitting at 1.6% right now!), and a fixed mortgage on another house (at 3.74%). Our variable mortgage is up for renewal in a few months and we’ve opted to renew it with a fixed mortgage. We’ve been quoted 3.29% as of yesterday – and at that rate, we’re happy to lock in with a fixed mortgage.

    • Kevin says:

      That’s 3.29% for the next 5 years? I think that’s reasonable. The current variable rate is around 3%, so the additional risk is not worth it.

  9. With interest rates this low, I would look at refinancing any variable rates I have in the next year. Rates will go up, it’s just a question of when and how fast.

    • Kevin says:

      Sometimes I wonder if they really will go up. If the central bank wants to, it can keep the rates where they are even under the face of high inflation. The only problem is paying for foreign imports.

  10. […] more: Should I Convert My Variable Rate Mortgage to a Fixed Rate … ← Discovering Inexpensive Mortgage […]

  11. How you choose between fixed rate and variable rate depends on the economcic situation. At the rate the economy is currently going, I think it is better to opt for fixed interest rate.

  12. Jai Catalano says:

    For me it’s about less headaches. I never have to worry. Variable rates are great when life is dandy but if you are like me and don’t want to worry fixed is best.

    • Kevin says:

      This is true. Less worry, but you pay for that. Though, if you’re in the market for a new mortgage right now the variable looks like a lose-lose.

  13. CF says:

    We’re in a similar situation with a variable rate of 2.15%. The fixed rate is tempting for the security aspect but we decided to stick with the variable rate for now.

    • Kevin says:

      2.15% is a great rate. With a rate like that, you can handle a few rate increases and still have paid less interest by the time it comes for renewal in 5 years out.

  14. Math says:

    2.3% right now, 0.5% increase per year, how did you get 3.35% in 5 years? To get 3.35%, the increase has to be 0.25% per year. So the numbers are off and the conclusion is completely wrong.

    • Kevin says:

      Thanks for pointing that out! I’ve updated the numbers. That’s what I get for staring at code for too long and thinking in multiples of 8. ;)

  15. […] Invest it wisely has a great article on whether you should convert your variable rate mortgage. […]

  16. Echo says:

    It’s more likely that interest rates go up 50 points over the next year and then pause for a while rather than continuing to go up every year. Like many have said here, the U.S. isn’t raising rates any time soon…so we can’t get too far out of balance with our rates in Canada or the Loonie will sky-rocket.

    I’m in a variable rate position (2.20%) and I’m going to wait it out instead of listening to a bunch of predictions.

    I agree that a first-time home buyer or someone renewing their mortgage right now should take the fixed rate. Even 10-years at 3.99% is pretty attractive if you’re confident you’ll stay put for a while.

    • Kevin says:

      Agreed that’s definitely a very important consideration. I doubt the Canadian central bank would be too happy with a Canadian dollar that starts to go to $1.20 US, $1.30 US and beyond. It would be cool for buying stuff abroad, but would cause other problems.

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  18. […] CF: Brian and I are in a similar situation. We have a variable rate mortgage at 2.15% over five years.  We’ll probably stick it out […]

  19. I’d rather go fixed and sleep well knowing I control the future payments. Rates will go up, when? 1 year? 3 years? Rates will rise at some point, don’t gamble with your largest asset.

  20. […] of that interest is to the company) and asking for it. Another interesting strategy in the whole mortgage game is to approach a couple direct competitors about switching over. Many salesman and employees […]

  21. Kyle Pearce says:

    Great post comparing the biggest question mortgage seekers will ask other than “what is your best rate?”

    A few years back, I would definitely recommend the variable rate mortgage to my clients, but now I think most feel better off paying slightly more for the fixed. Myself, I am always in the variable rate game since most lenders will allow you to “fix” your rate at any time.

    With that in mind, if rates do begin to rise, you can cut your losses and lock in. On the other hand, if rates begin to fall, then you’re receiving even more savings over the initial fixed rate.

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