Fixed Versus Variable – THE Mortgage Question

I’ve been meaning to write this blog post for many, many months – and I’m thrilled that I’m finally sitting down to do it.

The good news is there is a simple answer to the fixed vs. variable debate.  Are you ready? The answer is… It depends.

Ok, so that answer isn’t so simple, so let’s get into more detail.  Before I start, I will confess that I like safety. I drive a Volvo and my first mortgage (which I received well before I became a mortgage broker) was a 10-year fixed mortgage at 4.95%.  At the time, I thought that was the smartest business decision of all time, but clearly I was wrong…

Here are some questions to consider when selecting between a fixed and variable mortgage rate.  Note that these are general examples and you need to consider your specific situation and work with your mortgage professional before making a decision…

1)     Can you even qualify for both options?!

The new government stress test means you’ll need to qualify for your mortgage based on the GREATER of:

1. The benchmark rate (Currently 5.34% at January 2019)
2. The contract mortgage rate + 2.00%.

Example 1  – if the variable mortgage rate is Prime – 1.00% (3.95%-1.00%) = 2.95%, so the stress test is 5.34% (because the contract rate + 2.00% is only 4.95%)

Example 2 – if the fixed rate is 3.74%, then the stress test is 5.74% (because this rate is higher than the benchmark rate)

Given the high cost of real estate, in today’s market, it might be possible that you can qualify for your mortgage at the variable rate, but not at the fixed rate.  In this case you have no option but to take the variable rate (or don’t get a mortgage!)

Now, assuming you can qualify for both, here are some other questions…

2)     Can you SLEEP at night if you have a variable-rate mortgage?

I’m a big believer in the term PSYCHOGRAPHICS, which is the study of consumer attitudes and beliefs.  Even if you save some money with a variable-rate mortgage, it probably isn’t worthwhile if you’re going to spend the next 5-years worrying about interest rates, watching every single news report, second-guessing your decision, etc.

3)    Do you understand mortgage penalties, IRD and how they can impact you?

It’s important to understand that approximately 60% of borrowers break their mortgage within a 5-year term.  Of course, nobody expects to break their mortgage, but people get divorced, move cities, get married, change jobs, need to refinance to consolidate debt, upsize/downsize, want to buy a cottage/rental property, etc.  It’s not wise to argue with statistics! Simply put, banks and mortgage lenders want to lend you money and then get it back at the end of the term – not in the middle of the term! If you pay back the mortgage early, there will be a penalty.  The penalty to break a variable-rate mortgage is generally three months of interest on your outstanding mortgage, but the penalty for breaking a fixed-rate mortgage is generally the GREATER of three-months of interest on your outstanding mortgage or the Interest Rate Differential (IRD).  The IRD penalty can be massive – sometimes over $20,000. Check out this video on IRD as it explains the concept well. Of course, working with a good mortgage broker can help you to mitigate these penalties… https://www.youtube.com/watch?v=UpoeDpTKxXU

4)    Do you expect your income to rise? Are you leveraging math and statistics?

Most people earn more money over time.  They get promoted, change jobs, or maybe get married and become a dual-income family.  So even if interest rates increase over time, you should be able to afford them with a higher income.  In addition, paying lower interest rates earlier in your mortgage is more important than lower rates later on in the term – so if your variable rates start lower but increase, you can still be saving money compared to fixed rates.  Statistically speaking, studies have shown that most people are better off with a variable-rate mortgage.

5)     What is the spread between fixed and variable rates, and how is the economy?

Normally, you’d like to see a discount of at least 0.75% or more on your variable rates compared to fixed rates.  A few months ago, economists were expecting 3 or more rate hikes in 2019. If you were getting a mortgage in late 2018 and the discount was only 0.60%, AND rates were predicted to rise 3 times in 2019, fixed might have been a stronger consideration.  Of course, now we know that the economy is fragile, and rates are not expected to rise as quickly – SOME are predicting rate decreases now.

6)     Do you REALLY understand how an increase in variable rates impacts you?

It can be scary for some to hear that rates are increasing a few times in a year – but what does that actually mean?  If rates increase from 3.20% to 3.70% on a $500K mortgage with a 30-year amortization, your monthly payment would increase by $137.  Sure, it isn’t fun to see your monthly payment increase, but most people can afford the extra money. Plus, the fixed rate probably would have been higher anyway at the time of sign-up…  Of course, there is a risk that rates increase by 1.00% or more, but many feel that is unlikely, as this could put the entire economy into a recession. BONUS TIP – Some lenders won’t even increase your monthly payment if variable rates increase!

Here is a cool idea, which I call “The Canadian Option”… You can use your increased payment privilege to increase your payment AS IF you had a fixed-rate mortgage.  Then, if rates rise, your payment won’t likely change because you’re already paying the higher payment amount.

For example, assume your variable rate is 3.20% but your fixed rate would have been 3.79% – and the associated monthly payments would be $1725 and $1855 respectively.  You can select the variable mortgage but increase your monthly payment by the $130 difference (to match the monthly payment on the fixed-rate mortgage) and that extra money goes directly towards your principal.  Then, if rates rise, your payment won’t likely change because you’re already paying the higher amount.

Summary:

There are many factors to consider when deciding between a variable and fixed rate mortgage.  Statistically speaking, you are more likely to ‘win’ by going variable (due to lower rates earlier in the mortgage plus lower penalties), but other factors, including ‘stress’ might impact your decision.  Before becoming a mortgage broker, I opted for a fixed-rate mortgage, but after being in the industry, I have now selected a variable rate. It is best to speak with your mortgage professional before deciding.  And you will only know if you made the correct decision at the end of your term!