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%|
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|
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|
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.