Much has been written about the merits of fixed- and variable-rate mortgages. These discussions usually boil down to the likelihood of saving money with a variable-rate mortgage. However, a more important consideration is whether prospective homeowners can handle higher interest rates at the end of the mortgage term.
A quick check of current mortgage rates shows that borrowers with a good credit rating can get a variable-rate mortgage at 2.3% and a 5-year fixed mortgage at 3.8%. On a $250,000 mortgage with a 25-year amortization period, this difference in rates makes a significant difference in monthly payments:
Variable (2.3%): $1095
5-year fixed (3.8%): $1288
That’s an extra $193 per month for the security of a 5-year fixed rate. But how much security do you really get from a 5-year fixed mortgage? Suppose that interest rates rise by 1% per year for each of the next 5 years. This is the scenario that we are trying to protect ourselves from when choosing a fixed mortgage. Here are the variable rate monthly payments:
Start of Year 1 (2.3%): $1095
Start of Year 2 (3.3%): $1217
Start of Year 3 (4.3%): $1342
Start of Year 4 (5.3%): $1467
Start of Year 5 (6.3%): $1593
Start of Year 6 (7.3%): $1719
Does that payment to start the sixth year look scary? The fixed 5-year term payment of $1288 certainly looks good in this scenario. However, what happens when you renew after 5 years? The new 5-year term rate will be 8.8% and the monthly payment will be $1902. This looks pretty scary as well.
Choosing a 5-year term only puts off the day of reckoning if interest rates rise. Before buying a house, you should consider whether you could afford the potentially much higher payments in 5 years. If you could afford $1902 per month in 5 years then the choice today between variable ($1095) and 5-year fixed ($1288) looks like less of a big deal.
If a 5% jump in interest rates over the next 5 years would crush you financially, then you should seriously consider renting, buying a cheaper house, or seeking a term even longer than 5 years. The choice of fixed- or variable-rate mortgages is less important than deciding whether you can afford the higher payments when your term is up.
Please note that I’m not predicting that interest rates will rise by 5% in the next 5 years. I have no idea what interest rates are likely to do beyond what the yield curve says. As a prospective homeowner, you need to accept that there are many possibilities for the future of interest rates. You need to protect yourself against reasonably probable bad outcomes.