Fixed Rate and Variable Rate Mortgages: Which is Better?

With the recent “scary news” coming from economists and the Bank of Canada, it appears that interest rates will start going up this summer. Indeed, as I showed in Interest Rate Mania: Where is the Housing Market Going?, interest rates are at historical lows and it wouldn’t be prudent to expect them to stay this low.

If you’re a first-time home buyer on the market, then one of the big questions on your mind is probably “should I go with a fixed rate or a variable rate?” Since you pay a significant part of your interest in the beginning of your mortgage, the decision could have a significant impact on how much interest you wind up paying, and how long it will take to pay off your mortgage.

I decided to learn more about what the blogging community thinks about this, so I read several blogs about this topic, and it basically boiled down to this:

• You will save more money over the long run with variable rates.
• You might sleep better at night with the security of a fixed rate.

So, how true is this? I read a lot of anecdotal tales, but I was interested in just how much you save with a variable rate, and when it might not be good to go with a variable rate. I compiled data freely available from the Bank of Canada, and set up the following analysis:

• Our new home buyer is looking for a mortgage of $250 000.
• For the fixed rate, I used the 5-year conventional mortgage rate, and applied a discount of 1.30%; this is similar to the rate you can get at the bank today with a good credit history.
• For the variable rate, I used the prime rate with a discount of 0.30%.

Why over 5 years? Even if your amortization is 25 years, the typical mortgage loan is done over a 5 year period. This means that after those 5 years are up, you can switch to a different type of mortgage. With some banks it is even possible to switch before the 5 years are up.

This analysis thus takes into account bank lending practices as they exist today, and not as they might have existed 10 years ago or how they might exist in 10 years from now. First, let’s take a look at the rates over the past 35 years or so:

As we can see, paying off a mortgage from the end of the 1970s through to the end of the 1980s would have been pretty rough. The inflation of the times led to sky-high interest rates in an attempt to curb that inflation. I was only a child in the 80s, so I don’t personally remember the high interest rates, but I do remember that the housing prices were much lower than they are today.

Since the 90s and this decade, interest rates have been low in comparison with the 70s and 80s. In fact, they are currently dirt cheap. In addition to the cheap interest rates, housing prices have risen dramatically over the past decade. The lower interest rates account for a significant part of this; a $250,000 mortgage amortized over 25 years would cost you only about $1 183 per month at a 3% fixed rate, but that same mortgage amount would cost you $1 751 at 7% and a staggering $2 580 at 12%. When interest rates are low, it is much easier to buy a more expensive house, but I digress, since this post is supposed to be about the mortgage rates and not about housing prices 🙂

The amount shown below is the total interest paid over the first 5 years of a 25-year amortization, with the mortgage beginning on that year. For example,  for 1975, the amount shown is the total amount of interest paid from 1975 to the end of 1979.

For variable rates, the same analysis was done, but on a month by month basis using the current month’s rate:

Finally, here is the money you would have saved by going for a variable rate instead of a fixed rate:

If you had a variable rate mortgage in the late 1970s, you would have gotten creamed as compared to a 5-year fixed rate; however, the variable mortgage soon would have outpaced fixed once we entered an environment of falling interest rates in the early 1980s.

Fixed rates also held an advantage following Black Monday (1987) as the prime rates shot up; however, the rates dropped significantly starting in 1990, swinging the balance back in variable rate’s favor. Since the comparison is over five years, we can see that variable rate saved more money starting in 1988.

Since then, you would have saved tens of thousands by going for variable; at worst, you would have overpaid by a couple of thousand dollars as compared to a fixed rate. However, in the recessions of the late 1970s and 1980s, fixed rates held a significant advantage over variable. This is because following both of these recessions, interest rates shot up as central banks tightened monetary policy.

In a period of rising interest rates and uncertainty, fixed rates can be better than variable rates. They will certainly help you sleep better at night! Once things do get better, however, the advantage is clearly with variable rates.

So, what do you think? Have you already locked in a fixed rate? If not, are you still interested in locking in given the recent rate hike by banks? Although we cannot predict interest rates with certainty, I would recommend that if you are buying a new property, then calculate how much things would cost with a 7% rate. If you can still afford it even at a high rate, then you will be able to sleep better at night, knowing that you are prepared should it come!

Update:

Canadian Mortgage Trends has a very good post about this very same topic. They have modeled what would happen over the next few years if rates rise, and they found that “even with prime rate jumping 2.75 percentage points in 19 months, the variable-rate mortgage actually comes out ahead by a few thousand dollars.” It is certainly an interesting analysis and well worth checking out. However, if you are looking for a mortgage, you have access to a professional… your mortgage specialist! Have him or her draw out different scenarios and see where you would stand. Once armed with data, it will be easier for you to make an informed decision, in that case.