Let’s circle back on this classic question when choosing a Mortgage product …
Should I go with a fixed or variable rate Mortgage?
Let’s provide some structure to this post with a trusty list:
- Variable rate fundamentals.
- Universal acknowledgement.
- My answer.
Variable Rate Mortgage Fundamentals
When helping clients in this decision, I ensure there is fundamental understanding of how a variable rate Mortgage fluctuates, and why. Let’s unpackage some of these fundamentals:
- The Bank of Canada moves the national key lending interest rate based on various macro-economic factors (be sure to visit my blog for updates on these various factors like inflation, employment, etc.)
- Movements in the Bank of Canada’s policy rate change the Prime lending rate at commercial banks (RBC, First National, RMG, Scotia etc).
- Variable rate Mortgages are linked to the Prime lending rate at commercial banks. When the Prime rate moves, variable Mortgage rates move.
- Variable Mortgage rates have a set relationship to the Prime rate. For example, a variable Mortgage rate might be Prime – 0.50%. If the Prime rate is to change (up or down) the relationship to Prime is still Prime – 0.50%. The relationship to the Prime lending rate is set for the term length of your Mortgage (5 years etc).
- Variable rate Mortgages are convertible. This means you can convert your variable rate Mortgage to a fixed rate Mortgage, with the current lender, with no fee. Each lender will have different nuances when converting a variable rate to a fixed rate, but fundamentally, this is an option.
- A rule of thumb: a 0.25% rate increase will result in a payment increase of about $12 for every $100,000 of Mortgage debt there is.
- A major difference between fixed and variable rate Mortgages, other than the fact one changes over time and the other does not, is variable rate Mortgage penalties are only ever a 3 month interest rate penalty. Fixed rate Mortgage products typically charge the greater of a three month interest penalty or a interest rate differential penalty.
Universal Acknowledgement
Choosing a variable or fixed rate Mortgage is not good, bad, right or wrong. The choice is yours. I help facilitate understanding, ask you questions, and am a part of this conversation. I want my clients to have a stake in the outcome of their decision. I’m not here to judge people’s decisions. You get it.
My Answer
Should you go with a fixed or variable rate Mortgage? It depends. This is likely the most irritating answer to provide you, so let me explain …
I like my clients to understand some basic concepts:
- What is the near, medium and long term interest rate outlook from the Bank of Canada?
Let’s all acknowledge the uncertainty in this conversation. At any time in history, we make the best decisions with the information at hand. We make a plan, and adjust along the way. - What is the difference in rate between fixed and variable interest rates? Fixed rates are usually higher than variable rates. When choosing a fixed rate, I am essentially paying a premium for security of that product. When choosing a variable rate, I am paying a discount but have exposure to the risk of rising rates during the term of my Mortgage.
At various times over the years, this delta between interest rates has been very large (1%) and narrow (0.25%). In general, and depending on the anticipated interest rate outlook at the time, spreads at or above 0.50% generate more interest in variable rate Mortgage products. This means a variable rate Mortgage is 0.50% less than a fixed rate. - What are reasonable near and medium term Mortgage/Real Estate plans for you? For example, a couple planning to have a baby might want more security of a fixed rate at that time in their lives.
A long-term homeowner with solid equity, strong employment and more risk tolerance might be more inclined for a variable rate.
Perhaps a client is renewing their Mortgage is in the midst of a looming divorce? In this case, perhaps renewing into a variable rate Mortgage might be best to limit any potentially high interest rate differential penalty charge?
Maybe refinancing into a variable rate Mortgage is best in planning to purchase a second home because that lowers the Mortgage payment enough to be of assistance in qualifying for the next purchase?
These are some examples that I hope you can see when asked, should I go fixed or variable, the answer depends on you!
A Hybrid Approach
9 times out of 10 clients will initially want a fixed rate Mortgage. And that means at either a conscious or subconscious level, those clients are OK with paying the premium for the security of a fixed interest rate. In some cases, as outlined above, a client’s mind can change to wanting a variable rate Mortgage. If this change occurs, a hybrid approach might be an additional thought to consider!
The hybrid approach is this …choosing to arrange a variable rate Mortgage with the lender, but setting the clients Mortgage payment as if they were in a fixed rate Mortgage. Simple eh?
All dollars above the minimum required variable rate Mortgage payment go directly toward the principal balance of the Mortgage (re: accelerated Mortgage payoff). If the Bank of Canada does hike the national interest rate, the variable rate Mortgage payment would change. In many cases, the payment that was set artificially higher would not change. The amount going toward principal and interest would change, but not the higher payment that was set. Eventually, if the Bank of Canada continued to hike rates, the Mortgage payment would change.
For example, say a clients fixed rate Mortgage payment is $1,000/mo. If the client chooses a variable rate Mortgage, the required payment, at current interest rate levels is $935/mo. The client could arrange a variable rate Mortgage and pay $935/mo but set their payment to be $1,000/mo. This extra $65/mo goes toward the principal balance of the Mortgage. If the Bank of Canada hikes interest rates, and the variable rate Mortgage payment increases to $960/mo the clients $1,000/mo payment does not change. The amount going to principal and interest would change. Go it?
Conclusion
Client: “Should I go with a fixed or variable rate Mortgage?“
Chad: “It depends”.
Client thoughts: such a cop-out answer :-).
I hope reading above is helpful in understanding some different thoughts when choosing a fixed or variable rate Mortgage.
First, understand myself as a person. Honestly, can I handle the thought of interest rates potentially rising? For some, the conversation ends right there. Great!!
Second, if I am considering a variable rate Mortgage then we continue down the garden path of this conversation which is not linear.
I hope this is helpful for you! If so, let me know. Questions? Comment below. Share this content with others who are considering a fixed or variable rate Mortgage. And finally, thank you in advance for referring your people to my service.
Talk soon,
Chad Moore
P.S
I cannot believe how often spell check picked up my butchering of the word variable. Wow!
