Too many discussions of whether you should go for a fixed-rate or variable-rate mortgage center on trying to predict future interest rates. This is a waste of time. I don’t believe anyone can guess future rates better than the yield curve. Even if someone out there has a better prediction, I couldn’t distinguish him or her from all the other prophets who claim to see the future, but can’t. We should simply view fixed-rate mortgages as a kind of insurance.
To make things a little more concrete, suppose you’re trying to choose between a variable-rate mortgage that starts at 2.75% and a 10-year fixed-rate mortgage at 4%. On a $250,000 mortgage in Canada amortized for 25 years, the monthly payments are $1151 and $1315, respectively. I think of the extra $164 per month (about $20,000 over 10 years) as a premium for insurance against rising interest rates.
It’s tempting to try to guess which mortgage will be cheaper. After all, if interest rates rise to the point where your average variable rate over the 10-year term is more than 4%, you could come out ahead with the fixed rate. But this line of thinking is a waste of time because we just don’t know what will happen to interest rates. It’s better to focus on whether you need the insurance.
All insurance is priced to earn a profit, and fixed-rate mortgages are no different. Most of the time people who buy insurance lose money on the deal, and variable rate mortgages end up cheaper than fixed-rate mortgages most of the time. The purpose of insurance is to protect you from financial losses so great that you couldn’t recover. We don’t buy fire insurance because it is a bargain; we buy it because the financial loss of a burnt-down house is so great for most of us that it’s worth it to over-pay for protection.
Applying this insurance principle to a fixed-rate mortgage, we need to examine the bad outcome we fear. What if variable mortgage rates rise to 10% over the next 5 years? This would drive your monthly payments up to about $2200. Would this break you financially? Would you lose your house because you couldn’t make the payments? If your answer is yes, then you should consider the fixed-rate mortgage. If you have lots of margin in your finances and could tolerate this rise in payments, then a variable rate mortgage may be your best choice.
One thing to keep in mind is that your insurance only lasts for the 10-year mortgage term. After that, you are subject to prevailing mortgage rates. Fortunately, at that point you’d only owe about $178,000 on your mortgage and would likely be in a better position to handle higher rates.
However, most people only consider 5-year terms for their mortgages. The value of this insurance is much more modest because you could be hit with higher rates in only 5 years. Still owing $218,000 after 5 years, would you really be in a much better position to handle higher mortgage rates than you were 2 or 3 years into your mortgage when you had the insurance?
Instead of trying to predict future movements in interest rates, choose between fixed- and variable-rate mortgages by thinking about your ability to handle big jumps in mortgage rates. And be careful about the length of term you choose because the benefit of a fixed term goes away when the term ends.