Monday, November 5, 2012

Treat Fixed-Rate Mortgages as a Kind of Insurance

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.


10 comments:

  1. Your point about insurance on 'can't afford the house anymore' is exactly why I go long term on mortgages. I think the smart money says go shortterm, but I'm not prepared to handle the downside of doing so.

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  2. @Glenn: If you think only about the expected outcome, then variable rates make sense, but if you're concerned about being able to afford much higher payments, locking in a rate for the long term makes sense, as you say.

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  3. If all interest rates were perfectly priced based on future moves, fixed and variable rates should have the same outcome on average. Because of the uncertainty it makes sense for fixed rates to be more expensive if there is a likely possibility (but not a certainty) of higher rates in the future. On the other hand if there is a likely possibility of falling or low rates then fixed rates could be priced cheaper than variable rates in anticipation, and if the rates did not go or stay as low as expected the fixed rate would come out ahead.

    That said, with all the securitization and trading of debt it seems like mortgages are priced based on the lending market much more than a single lender's interest rate forecasts and risk tolerance (except when the lender decides which side they want to be more competitive on with a lower profit margin). If enough people in the lending market have irrational preferences that could lead to irrational pricing of mortgages.

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  4. @Value Indexer: I guess it depends on what you mean by "perfectly priced based on future moves". If you mean that we know in advance what the actual future interest rate moves will be, then we are talking about a world that doesn't exist. In reality, many outcomes are possible, and the best we can hope for is to characterize the probability distribution correctly. This means that there is uncertainty in the outcome and there will be a risk premium for whichever side takes the risk. This is why, on average, fixed-rate mortgages are more expensive than variable-rate mortgages.

    It may be true that we sometimes have irrationally-priced morgages, but we usually only recognize such situations after the fact.

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  5. Good post Michael. Fixed-rates are indeed a type of insurance premium to hedge a spike in lending rates.

    I'm kinda kicking myself, I took a 5-year term @3.3% and I should have taken variable. I'm almost halfway through the term.

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  6. @Mark: Thanks. I think you're being too hard on yourself. If you needed the protection from rising rates, then you made a sensible choice. Among all the possible outcomes over the past 2.5 years, having interest rates rise to say 6% was not out of the question. They may yet rise by the time you have to renew. If this happens, you'll be glad you've been succeeding at your financial goals. I'm not predicting a rise in rates, but just observing that this is one of the possibilities.

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  7. bond market cycles run in extremely long 30 year cycles. consider this. the last peak was in 1980-1, arguably we've hit some bottom that (when compared to the 30's depression), can last for 7 years ±.

    question is: when not if they will go up?

    The articles idea of longer-term fixed rate for insurance is excellent. Do you want insurance from this reliable trend?

    epter

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  8. @Epter (Peter?): I don't think bond market cycles are particularly predictable, but it seems that interest rates have nowhere to go but up. Rates may or may not rise, but the important thing to think about is whether your finances can withstand rising rates.

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  9. Where do you get a fixed 10 year mortgage in Canada?
    Fixed mortgages do not exist in Canada, as they do in the US, where you can get the same rate for the durating of the morgate (20, 25 years)
    In Canada they are the same as variable, but a much better deal for the banks, who can adjust the rate every 3-5 years while increasing their rip-off by a couple of points, while the "fixed-rate" customer is stuck with an illusion of safety...

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  10. @Anonymous: According to ratesupermarket.ca, there are 16 lenders with 10-year fixed closed mortgages, and RBC offers a 25-year fixed mortgage. I agree with you that 3-5 year fixed-rate mortgages mostly give the illusion of safety, as I argued in my post.

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