A lot of people in the mortgage biz like to tell customers: “Pay your variable like a fixed.”
In other words, increase the payment on your adjustable-rate mortgage (ARM) to match the payment you would have made, had you chosen a 5-year fixed.
The purpose of this strategy is to pay more up front so that if rates (and your payment) rise, you’ll feel it less.
In other words, it creates a buffer of sorts — so your monthly cash flow is not impacted when the Bank of Canada hikes. (Side note: This strategy is not applied as often on variable-rate mortgages — which have fixed payments to begin with.)
How Does it Work?
You might be wondering how effective this strategy really is.
Let’s make a few assumptions and find out.
Suppose for a minute that:
- You’ve got a standard mortgage of $250,000
- The best 5-year fixed rate is 3.59%
- The best adjustable mortgage rate is prime – 1.00% (2.95% as this is being written)
- The Bank of Canada hikes rates multiple times over the next year.
Given the above hypothetical, paying your ARM like a fixed will save you roughly $121 in interest and shelter you from three rate hikes.
After that, you’re at the mercy of prime rate. If the Bank of Canada raises a fourth, fifth or sixth time, you have to raise your payment again (and potentially again and again) to cover those hikes.
Useful But Over-hyped
Do we recommend this strategy? Sure, why not. But only if you have nothing better to spend your money on (like paying down higher-interest debt, building an emergency fund, investing and so on).
The concerns we have are these. Many mortgage advisors:
- Position this strategy like it’s sheer genius from above
- It’s just making prepayments, folks. Nothing more.
- Recommend this as a way to reduce risk in a variable rate and put clients at ease
- In fact, as is shown above, the risk mitigation of this strategy is limited (unless you increase your ARM payment more than the spread between fixed and variable rates suggest).
- Tout it, but don’t know how effective it is
- It’s true. Many brokers and bankers have never done the math so they have little idea how much you’ll save (or how many hikes it’ll insulate you from) if you follow their advice.
- Do not account for superior uses of the prepayment money
- Carrying a 20% interest credit card balance? In most such cases, prepaying a mortgage is a chump move.
But it’s not always about dollars and sense.
“It also has a significant emotional benefit — paying down debt faster and buffering for payment ‘shock’ as they call it,” says Dustan Woodhouse of Be The Better Broker Inc.
“We purchase comfort by padding the payment…but it’s potentially an opportunity cost for those dollars that could be deployed elsewhere at a greater monetary return,” he adds.
Woodhouse’s advice for many (not all) is this: “Pay the rock-bottom payment you possibly can because these are ridiculously low interest rates. Then invest the balance somewhere else.”
If you’ve got a long time horizon and “you don’t have better than a 4% [after-tax] return somewhere else in your life, you need better investment advice,” he adds.
The benefit of the “pay-your-ARM-like-a-fixed” strategy is often overstated because variable-rate borrowers are already stress tested for a 200 bps rate increase by their lender. Moreover, with today’s rates, doing this only “protects” you from about three hikes. After that, you’re exposed and the strategy’s value largely expires.
On top of all this, advisors often recommend this tactic without checking if there are better and higher uses of the borrower’s funds. That’s a mistake.
If you hear a mortgage person touting this strategy, ask them:
1) how much it will save you (in dollars based on your mortgage details)
2) how many rate hikes it will shelter you from.
You might get a delayed response because they haven’t run the numbers. When searching for people to interview for this story, we spoke with three seasoned brokers who recommend this strategy. Only one knew roughly how many rate hikes were required before the borrower would have to increase their payment.
Brokers and bankers should know the basic math cold, quantify the pros and cons, and proactively acknowledge opportunity costs in any strategy they advocate. That’s how you know you’re getting professional advice.