Fixed or Variable Rate? The Decision Checklist

Mortgage rate questionsAlmost every mortgage shopper has the same question at some point, especially when rates are surging:

“Should I Lock in My Mortgage Rate?”

Answer this correctly and you’ll save thousands in interest. Pick the wrong rate type, and it could cost you just as much.

These days, seemingly everyone’s got an opinion on fixed or variable rates. But unless they’ve taken the time to understand your personal finances, your plans and your comfort level with rate volatility, their 2 cents is worth just about….2 cents.

What follows is a checklist of decision factors that everyone needs to weigh when deciding between a fixed and variable rate (or a long or short term).

******

Reasons to lock in

☐ You’re Worried It’s Different This TimeWorried about mortgage rates

  • Prominent research suggests that fixed rates underperform variable rates, but that conclusion depends heavily on the rate assumptions used.
  • Historical backtesting confirms that when the best fixed rates are close to the best variable rates (e.g., about 0.25% apart), 5-year fixed rates have outperformed more than 4 times out of 10.
    • Some Perspective: Research is always a rearview mirror. It may be a good indicator of long-term trends, but doesn’t tell us what’s coming in the next five years, or factor in changing inflation and bond market risks. (Inflation threats and high demand for borrowing can both drive rates higher.)

☐ You Can’t Afford an Interest Spike

  • A one-point hike in rates will cost you roughly $80 more interest each month for every $100,000 of mortgage.
  • If you’ve got a variable mortgage with fixed payments, you shouldn’t experience payment shock.
    • There are rare exceptions, namely when rates jump so much that you’re not covering your interest. Most lenders will then raise your payments.Interest rate spike
  • By contrast, if you have a payment that floats with prime rate, a hypothetical 2-point rate hike would jack up those payments by $300 a month on a $300,000 mortgage.
  • In the three rate cycles prior to the financial crisis, prime rose an average of 3.16 percentage points from its trough to its peak.
    • Spy Tip: If you want to be ultra-conservative, use this mortgage stress test calculator and check what your payments could rise to with a 3.00point rate hike. Barring that, assume a 2.00-point hike.

☐ The Break-Even Rate is Low

  • Imagine you can get a 2.00% variable. If we make some basic assumptions, here’s how high rates must rise for that variable rate to cost you more interest than a 5-year fixed:
    • 0.50 percentage points for a 2.19% five-year fixed mortgageBreak-even point for variable mortgage rates
    • 0.75 percentage points for a 2.29% five-year fixed mortgage
    • 1.00 percentage point for a 2.39% five-year fixed mortgage
  • As these numbers illustrate, the lower the 5-year fixed rate (relative to variable rates), the lower your breakeven rate—and the better your chances in a long-term fixed.
    • Spy Tip: When the difference between a long-term fixed rate and a variable rate is less than 1/2 a percentage point, you’re paying very little (historically) for the insurance of a fixed rate.

☐ You Think You Can Time Rates

  • You can’t. And if you can, you should be running a hedge fund making an 8-figure salary.Predicting mortgage rates
  • Not only will the bond market fake you out like an Allen Iverson crossover, but even if you could precisely predict rates in the next year, it would do you no good, research shows.
  • And don’t think you can lock in at a good rate when you see prime rate increase. Bond yields—which steer fixed mortgage rates—almost always rise several weeks before the Bank of Canada hikes rates. By the time you lock in, yields will have probably lifted 5-year fixed rates by 30 to 60+ basis points.
    • Be aware: Lenders often shrink their discounts when surging demand for fixed rates outpaces their supply of funding.
    • Spy Tip: If you’re prone to lock in your variable-rate mortgage, don’t gamble. Get a fixed rate from the get-go.

☐ Rates are Near Zero

  • When Canada’s overnight rate isn’t far from zero, as is the case today (February 2017), it’s harder for banks to make money on variable rates. So they keep prime rate higher than the Bank of Canada’s overnight rate warrants, and/or they reduce their discounts from prime rate.Falling interest rates
  • In such an environment, even if the Bank of Canada does cut rates, the odds are low that consumers will see a matching reduction on their variable rate mortgage. That can diminish or negate the benefit of a variable rate.

☐ You Can’t Re-qualify

  • If there’s risk to your income (potential job loss, planned leave, etc.) you don’t want to worry about re-applying for a mortgage in 1-3 years.
  • You’re also more at risk if you’ve got less than 20% equity. In such cases, you cannot refinance in order to lower your payments.
    • Spy Tip: If your financial situation is less than solid, then—assuming a mortgage makes sense at all—lock into the best 5-year fixed you can find.

☐ You Might Break Your Mortgage

  • The average borrower in a 5-year term renegotiates and/or breaks their mortgage in about 3.8 years.
  • The fee for paying off a 5-year fixed mortgage early can easily cost you thousands, especially if your lender charges an “interest rate differential” (IRD) penalty.
    • Spy Tip: The more rates fall, the bigger IRD penalties can grow.Breaking your mortgage
  • With a variable mortgage, you generally pay just a 3-month interest penalty (the exceptions are low-frills mortgages, which have ugly penalties—up to 3% of your principal).
  • Even if rates go sideways, IRD penalties can be thousands higher than variable penalties, especially if your lender is a major bank or you have a “low-frills” mortgage.
  • Canada’s Big 6 banks have IRD penalties that are often more than double your typical mortgage finance company. See for yourself by plugging the exact same assumptions into a mortgage penalty calculator. Here’s an example of someone who got a mortgage three years ago and wants to break it two years before maturity:

Canada’s biggest bank:

Canada’s biggest non-bank lender:

  • These two scenarios use the exact same assumptions. Yet the bank’s penalty is more than twice as large as the non-bank’s.
    • Spy Tip: If you want the flexibility to refinance at another lender (at best rates) or break your mortgage before maturity, think hard before locking into a long-term fixed rate—especially at a Big 6 bank.

☐ You Might Move

  • Most fixed rates are portable if you change homes and want to take your mortgage with you to avoid a breakage penalty. Fixed rates are usually (but not always) increasable as well. That means you can increase the mortgage at the lender’s then-current rates without a penalty (a.k.a. “blend and increase”).
  • Most variable rates are also portable. But many are not increasable. Without a blend and increase feature, you’d have to break the mortgage and pay a penalty if you wanted to increase your loan. Variable-rate mortgagors who buy more expensive homes, and need more money, often find this out the hard way.

******

Reasons not to lock in

☐ You’ve Got an Amazing RateGot a great interest rate

  • If you can get a variable or short-term fixed rate that’s 75+ basis points below going 5-year fixed rates, your rate could jump over 1 percentage point and you’d still pay about the same interest cost as someone in a 5-year fixed.
    • Note: This rule of thumb doesn’t work if rates surge in the first 12 months of your mortgage.

☐ You’re a Disinflationist  

  • Rates will likely never gain much altitude so long as inflation stays near or below 2%, its average over the last 25 years.
  • Mega-trends like aging consumers, automation, offshoring, outsourcing, internet retailing, over-leveraged consumers and cheaper energy have conspired to suppress inflation.
  • If you’re betting on those trends persisting, and there’s a fair chance they might, then the threat of soaring inflation and monster rate hikes is less of a concern.

☐ You’re Financially Secure

  • Strong borrowers have ample room for sizable rate hikes.
  • What’s a sizable rate hike? 200+ bps.Financially secure borrower
  • What’s a strong borrower? Someone who has:
    • Enough savings to pay 6 months of their mortgage
    • A stable job
    • A reasonable consumer debt load, and
    • A mortgage payment, property taxes, utilities and condo fees that total less than 1/3 of their gross monthly income

☐ Your Mortgage and/or Amortization are Small

  • Risk is often relative to the size of your mortgage.
    • For example, paying a 2-point higher mortgage rate will cost you about $450 more interest each month on a standard $300,000 mortgage, but just $150 more on a $100,000 mortgage.
  • A small mortgage relative to your home’s value also affords you more options if you need to refinance to improve your cash flow.
    • Spy Tip:  Due to government regulations, it’s easier to get approved if your loan-to-value (LTV) is 65% or less. These low-LTV mortgages often have cheaper rates too, unless your credit is shabby.
  • Higher rates hurt less when you have a short amortization.
    • Here’s a simple example: Over five years, a 1.00%-point higher rate increases your interest cost almost 80% more if you’ve got a 25-year amortization, compared to a 5-year amortization.

☐ You’re a Risk-Tolerant Rate-hike Skeptic

  • The economists we know all prefer variable rates. Why? Because they know two things:
    1. It takes less monetary tightening to slow today’s over-leveraged consumers.
      • Whereas it might have taken a 3-point rate hike to control inflation in the past, today it could take half that.
    2. GDP has been in a long-term downtrend with no sign that we’ll return to the days of consistent 4%+ growth
      • Sustained 4% growth, even if only for 3-4 quarters, would almost certainly boost interest rates materially.

☐ If Rates Have Already Risen

  • History is clear on one thing. If rates are already up 150-200+ basis points, your odds of saving more in a variable soar.Rising interest rates
    • Spy Tip:  If rates have increased 150+ basis points from the lows of the cycle, financially stable borrowers should start looking at shorter terms, like a 3-year fixed rate instead of a 5-year fixed. Once rates rise over 200 basis points from cycle lows, all but the most risk-averse borrowers should consider short or variable-rate terms.

☐ Your Lender is Uncompetitive

  • When you lock in your variable rate to a fixed rate, the fixed rate you get is called a “conversion rate.”
  • Some lenders quote conversion rates that are more than ½-point above their best discounted rates. Scandalous!
  • If your lender is a rate pirate on conversions, that’s just one more reason to ride out a variable rate.

☐ Because Economists Predict Higher Rates

  • Your grandma can predict long-term rates as well as most economists. Research shows that economists have an optimism bias and can’t foresee recessions. Their Forcasting rising interest ratespredictions give you utterly no edge.
  • If you’re prone to rely on rate predictions that are wrong half the time, save yourself the guesswork and consider a hybrid mortgage (half fixed and half variable).

******

Boiling it down

Picking the right mortgage term is rarely a single-variable decision. People lock in (or don’t) for multiple reasons. What you need to do is weigh each factor above and ask your gut whether the risk of a variable is worth the reward of a variable. Then make the call on your own, because no one knows your situation better than you.


10 Comments

  • Mike says:

    Kudos for providing such an exhaustive checklist! I’ve been researching fixed vs. variable and weighing the pros and cons of each for some time now. I’m just about ready to enter the market and get my pre-approval, but I’ve been really torn as to which route to go.

    Given our situation, we’re now leaning towards locking in for 5 years given some of your points above.

  • Carolyn says:

    So, for a well qualified/financially stable person with 20% down, and I am open and willing to get a variable rate, it still seems that the 3 yr fixed are only 2.34 while you can still get the 2.35 HSBC 5 yr fixed. And for 20% down, the lowest variable rates aren’t available. In my case would you say the crusty 5 yr fixed is still the best bet at this point?

    • The Spy says:

      Hi Carolyn, Lots of factors to consider but based on interest cost alone, you can find variables today (Feb 28, 2017) at:
      * 2.15% (for 80% LTVs)
      * 1.84% (for 65% LTVs)

      At 80% LTV, paying just 20 bps more for a set-and-forget 5-fixed is a steal. One exception is if there’s a likelihood of breaking the mortgage before maturity. In that case, I wouldn’t want to get stuck with any big bank IRD penalty, including HSBC’s. As for the 3-year, there’s not a lot of value at 2.34%, relative to a 5-year at 2.35% — unless that term happens to match your anticipated mortgage duration.

  • Eric says:

    Love this website! We are first time home buyers and it was a real debate between fixed and variable. Ultimately decided to go variable 5-year closed. Got a great rate 1.85% (-85bps). Could of got a 5 year fixed for 2.45%. We are saving 60bps currently going variable. 335k mortgage, we put the min 5% down. Still not sure if I made the right decision? Your thoughts?

    • The Spy says:

      Thanks Eric, For someone with a financial safety net and solid job, a 60 bps spread in a low inflation environment is often a risk worth taking. To be safe, plan on at least 3-4 BoC rate hikes in the next 24-36 months, not because they’ll necessarily happen, but because you need to budget for the possibility. And be sure you’re putting any variable-rate payment savings to the highest and best use (building a savings buffer, debt paydown, investing, etc.).

  • Eric says:

    Thanks for the input Spy! We will be saving approx $100/month by going variable for now! Planning on putting that extra savings away into a separate account to build a nestegg in case rates go up. Using your awesome “what if” calculator, if rates go up less than 1% over the next 5 years we are ahead, if rates go up 2-3% we lose. We both have stable jobs and can afford the payments should rates increase. It’s a gamble but I think a good one! I just don’t see rates increasing drastically anytime soon. With so many borrowers living on the edge even a 2% increase can cripple the housing market! I don’t see the BoC taking that risk.

  • Omid says:

    Awesome article thank you!
    As of today July 25, 2017, I have two options to renew my existing mortgage:

    2.25 variable over 25 years amortization
    2.84 fixed over 30 years

    Both provides the same monthly payment. I’m leaning toward the variable rate. Do you have any suggestion ? In light of the recent .25% hike by BoC

    • The Spy says:

      Thanks Omid,

      If you’re well qualified my best advice is to shop aggressively, unless your mortgage is small and you’re happy with your existing lender. You can save up to 1/4%-pts off those rates, depending on your scenario.

      The fixed versus variable decision hinges on your answers to this checklist. Just keep in mind that the market is pricing in 1-2 more rate hikes minimum. If the Bank of Canada stopped after another 1/2 point of increases, the decision would be easy (for most qualified borrowers): go variable or short term. But there’s no way of knowing how much the BoC will have to raise to thwart inflation. I’m guessing it won’t be much more, given that inflation is near multi-year lows, but term selection isn’t a guessing game.

Leave a Reply

Your email address will not be published. Required fields are marked *