A fellow financial blogger asked my opinion about his upcoming mortgage renewal. He faces the same choice as many of us do: should you take a fixed-rate mortgage or go for the lower variable rate? The risk with the variable rate mortgage is that rates might rise. The answer requires surprisingly little math.
If rates stay the same for 5 years, then the lower variable rate will save you money compared to a 5-year fixed-rate mortgage. If rates go down, you’re even further ahead. Averaged over all possibilities, the average outcome is that you save some interest on a variable-rate mortgage. The worry, though, is the possibility that rates go up.
You can’t fully protect yourself against rising rates even with a 5-year fixed rate, because you’ll have to renew at a new interest rate after 5 years. But you might hope to get your balance down enough that you could absorb an interest rate increase in 5 years.
The real test of what you should do comes with looking at a terrible outcome. Suppose you could get a 2% variable rate today. What would your payment be if the variable rate shot up to 7%? This isn’t a prediction. We’re just looking at what happens in a scary scenario. It’s your reaction to this scenario that should drive your decision.
After calculating your mortgage payment at 7% interest, did you throw up? Did you look at it and know for certain you’d lose the house and everything else you own? Then a variable-rate mortgage isn’t for you.
Instead, did you look at the 7% payment and think that it would be no fun to pay this higher amount, but that you’d be okay? Then you can go ahead with a variable-rate mortgage.
A curious thing about this piece of advice is that I don’t know of anyone who has followed it. Some say it makes sense to them, but they never actually calculate the payment based on 7% interest. They just imagine a higher payment and declare whether they can handle it. This is useless without actually calculating the payment based on the much higher rate.
One explanation for not following this advice is laziness. Another possibility is pain avoidance. It’s no fun to imagine a much higher payment, and not calculating the higher payment avoids the pain. Whatever the explanation, deciding if you can handle a higher payment without actually calculating the higher payment amount is not helpful.