## Monday, March 7, 2011

### Mortgages: Fixed or Variable Rate?

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.

1. Canadians are at 150% debt to income. Inevitably, we are about to enter a period of deleveraging where the average Canadian will spend less on consumable goods and will spend more on debt reduction. In aggregate, Canadians owe \$1.5 trillion in real estate debt. The rise in real estate prices is not infinite and will ultimately cap with the average Canadian left with a tremendous debt. Real estate assets are being valued by the incremental buyer of today, but the future incremental buyer will pay less, and likely much less.

In that environment, deleveraging will put much more of household income towards debt repayment than consumer goods. In an environment with little to no demand for credit, the price of credit will be low -- meaning that interest rates will be low for the foreseeable future.

The easiest deleverage, at some potential family discord, is to sell dwellings into a toppy market. Volumes are already starting to drop which portends the torrent of listings as people realize how much of a hole they have dug into debt. Raise cash now. Cash is priceless when others have none. The bargains in another 12-18 months will be incredible by today's debt-fuelled heights.

The following is a fantastic read for the intermediate to advanced investor.

2. Let's try that URL again with something a bit shorter:

http://tinyurl.com/6jb4wdv

3. @Anonymous: You paint a picture of one future out of many possibilities. My point is that individuals need to make financial choices that will work out acceptably well in any reasonably probable future outcome.

4. When we move into our new house I'm going to stay variable. What worked well for me over the past 5 years is to choose the variable rate but pay the equivilent to the fixed rate. I was at prime minus 50, but I was making payments at 4.69%.

I've been told that we can get prime minus 75 now, so that makes the spread about 175 points. Chances are that interest rates will rise, but will they rise quickly enough to make this a losing deal for me?

Maybe, I don't know. I just hate to pay a premium now when we have no clue how this will play out over 5 years. Variable wins almost 90% of the time, and I like those odds.

5. @Echo: I'd probably choose variable myself. That can be a sensible choice as long as you think you could handle the payments if interest rates drift up significantly over time.

6. I wonder what the break even point would be in your example. How fast could rates rise over the term such that the variable interest equals the fixed? Looks like it's something less than 1% a year, perhaps 0.70%.

At any rate, I've always liked variable rate due to the interest rate differential. Even when pundits are saying there's an almost 100% chance rates will rise in the medium term, they are sometimes wrong. Also, I don't imagine they will rise that 0.70% per year for five years running, but I could be wrong.

7. @Gene: I like variable rates as well. However, my first mortgage was at 11% and I wouldn't feel comfortable having a mortgage now unless I thought I could handle the payments if rates went up to 11% again.

8. Gene, the first-order approximation is that if you're assuming rates are going up linearly, then you need to end the 5-years with a variable rate as far above the fixed rate as it was below when you started. E.G., if you have a variable-rate mortgage at 2.5%, and a fixed-rate at 4%, if rates went up steadily, you'd have to get to 5.5% at the end to breakeven. It would actually require a larger/faster rate increase if you're paying down your principal faster on the variable rate.

9. Michael - you stole this post out of my head! :)

I used to think that the 5-year fixed was good for everyone who couldn't handle an interest rate increase, which is why we got one a few years ago.

After some conversations with a colleague recently, it occurred to me that for someone who has a large mortgage, the five year fixed isn't really a lot of protection against higher rates. It's just not long enough for most people to pay down a large mortgage enough to get into 'safe' territory.

Now I think that people who can't afford an interest rate increase probably shouldn't buy the house. If they do buy the house, they might as well go variable.

I think I'm one of the rare examples of someone who had a largish mortgage and locked in because of an inability to handle significantly higher payments - but then paid off enough that by the time the five years is up - the mortgage will be small enough that there will be no interest rate risk.

I paid a lot more in interest compared to a variable mortgage, but the risk reduction was effective.

10. @Potato: You're right that there are some subtleties in deciding how much rates have to rise before a fixed term makes sense.

@Anonymous: Great minds think alike. And so do we, apparently :-)

11. FYI - I was the "anonymous" guy. I guess I made a mistake when entering my comment.

My mind is only great some of the time. ;)