Before we move into our new house this summer we have a really big decision to make. Do we go with a fixed or a variable rate? The answer to this question varies for everyone depending on their financial situation and tolerance for risk.
According to a popular study by Moshe Milevsky, choosing a variable rate has saved home owners money nearly 90 percent of the time. Sounds like an easy decision then, right? Not exactly.
This Time it’s Different
Interest rates are still at historic lows, with most experts predicting that rates will increase at least 1-2 percent over the next two years. Five-year fixed rates are currently under 4 percent, which is definitely an attractive rate to lock into and protect against the risk of future interest rate hikes.
But if the math favours choosing a variable rate mortgage over time, why are people so divided on this issue?
The vast majority of Canadians still choose the five-year fixed term. Proponents of fixed interest rates enjoy the peace of mind knowing that their payments won’t change and they also feel that we are in one of those rare situations where locking into a five-year term will save home owners money.
Since variable rates are always initially cheaper than five-year fixed mortgage rates, the decision ultimately comes down to saving money now vs. the potential of saving money in the future if interest rates go up.
What Options To Consider?
Let’s take a look at some real numbers to help make our decision. These are the current interest rate options for us, along with some pros and cons to consider:
- - Five-year variable interest rate = 2.20 percent (prime minus 0.80 percent) – As I mentioned, this is likely the smart choice since the variable rate has saved money nearly 90% of the time vs. a fixed rate. However, this time could very well be different, and if interest rates climb quickly back to historic levels this can become a losing proposition.
- - Five-year fixed interest rate = 3.89 percent – All things considered, a five-year fixed term under 4 percent is extremely low and would give us the peace of mind knowing that our payments wouldn’t increase even if interest rates soared. On the downside, by choosing this option we would be paying $260 more per month than if we went with the variable rate.
- - Three-year fixed interest rate = 3.54 percent – This option would give us the flexibility of not locking into a five-year term and also benefitting from a 0.35 percent discount over the five-year term. The monthly payments would still be $200 more than the payments on the variable rate.
- - 1 year fixed interest rate = 2.64 percent – This option might be the best for us if we feel this is still a period of uncertainty. We would maintain our negotiating power after just one year and we also benefit from a 1.25 percent discount off the five-year fixed rate. But if interest rates were to rise quickly over the next 12 months we would still have to renew our mortgage at a higher rate when it came due.
As you can see, the five-year fixed rate has a built-in premium of 1.69 percent over the best variable interest rate. If the Bank of Canada decided to raise interest rates fairly quickly and aggressively over the next few years, the five-year fixed rate would likely be the better option.
Economic Factors at Work
The Bank of Canada meets eight times a year to make interest rate announcements and historically will move the rate by 25 or 50 basis points (0.25 or 0.50 percentage points) at a time. There is definitely the potential for interest rates to move between 2 – 3% in a single year.
The problem is, we are not very good at predicting where interest rates are headed. When it comes to monetary policy, there are a lot of moving parts to consider. It’s not as simple as just trying to contain inflation or trying to prevent a housing bubble.
Think of the soaring Canadian dollar. If interest rates were to rise sharply, the loonie would continue to climb vs. the American dollar, which puts increasing pressure on our manufacturing sector that relies heavily on exports.
Interest rates are indeed at historic lows but, with the outlook of the world economy still very uncertain, it is likely that the Bank of Canada will continue to move cautiously to avoid triggering another recession.
The Affordability Factor
Ultimately, whatever we decide to choose will carry some risk. Often the fixed vs. variable interest rate question is more about affordability than anything. Can your budget handle a 2 percent – 3 percent hike in interest rates? If not, then the fixed rate gives you that peace of mind to know that your payments won’t change for five years. If you can handle an increase in mortgage payments then you might find a great opportunity to save thousands of dollars in interest over the life of your mortgage by choosing the variable rate.
In our case, I think we are leaning toward the five-year variable rate, but with a twist. We will set our payments as if we were paying a 4.5 percent interest rate. This way we will be knocking years off of the overall amortization of our mortgage while saving thousands of dollars of interest. And we will still have the peace of mind knowing that we have built in a 2.3 percent cushion into our monthly payments in case interest rates rise.
What do you think of our plan? If you had to renew your mortgage today, what option would you choose?
Robb Engen writes about Canadian personal finance at Boomer & Echo. Together with his mom, (she’s the Boomer, he’s the Echo) they offer their own unique perspectives on saving, investing and personal finance.