There’s a great post over at Million Dollar Journey weighing on the age-old variable vs. fixed mortgage rate debate, titled Avoid The 5-Year Fixed Mortgage Trap . In the post, writer Ed Rempel argues that Canadians are always better off with a variable rate mortgage, or a short term fixed loan rather than the traditional 5 year fixed. It turns out that Canadians are very willing to pay a premium for stability, a premium Ed argues they should avoid all the time.
Yet like most personal finance choices, this one isn’t all about the dollars and cents. Like Mike from Four Pillars pointed out in the comments, fixed rate mortgages give borrowers protection from rising rates. And while they do pay a premium for that protection, it’s a premium that people would gladly pay. How much is peace of mind worth? Every person answers that question differently, that’s the crux of personal finance.
Recently, we saw 5 year fixed mortgages for 3.69%. Even though rates have now gone up from those lows, could someone be better off with a 5 year fixed than a variable at prime minus 0.5%? (currently 1.75%) Remember, the Bank of Canada is widely expected to start raising rates in June. Let’s assume our imaginary borrower has a 200k mortgage, 25 year amortization. Let’s also ignore property taxes and other expenses for the sake of simplicity.
Let’s first figure out the interest expense over 5 years for the fixed rate person.
$200,000 mortgage 3.69% interest rate:
Monthly payment 1018.70
34,277.69 paid in interest
26,844.43 paid back in principal
173,155.57 still owing
The issue for figuring out the variable rate mortgagor is raising rates aren’t predicable. They could go up quite quickly, or fizzle out after just a few increases. For our discussion here, let’s look at rates going up at the pace that TD thinks they are. (I tried to just embed the chart, but with no luck)
TD thinks the Bank of Canada’s overnight rate will rise to 1.5% by the end of 2010, and 3% by the end of 2011. Prime rates are currently 2% above the Bank’s overnight rate. After 2011, obviously nobody really has any idea what’s going to happen with interest rates, so let’s run a few different scenarios: (Remember, prime minus 0.5% is the mortgage rate used)
1. Rates stay with prime at 5% for the remaining 3 years.
2. Rates rise 0.5% a year, peaking at 6.5% for year 5.
3. Rates fall o.5% a year, bottoming at 3.5% for year 5.
Payment goes from $895.93 per month to $1099.10. Total interest paid is $37855.66 for the 5 year period and the principal owing is $174374.81. The five year fixed person is ahead of the game, although only slightly.
Payment goes from the same $895.23 per month to $1253.72 in year 5. Total interest paid over the 5 year period is $43,273.93 with a balance owing of $176,037.33. This handily loses to the 5 year fixed option.
Scenario #3: This does much better, with the payment ending up at $954.96 during year 5. Total interest paid is $32,456.06 with $172,479.68 owing at the end of the 5 year term. This is a much more attractive option than 5 year fixed.
Whew! Okay, what does all this mean?
Now I know I’m using the benefit of hindsight here, but I think the people who locked in at 3.69% are going to come out the winners. Which of my three interest rate scenarios do you think is the most realistic? Will rates rise to a still relatively low level and stay there? Or will they keep slowly rising over time? I don’t have the answer, but unless they come back down after 2012 you’re better off with the stability of a fixed payment.
Please don’t lose sight of my point because I cherry picked the absolute best situation for fixed rate mortgages. The point is that although variable usually wins in the long run, fixed rate can also have its advantages. What’s certainty worth to you? Perhaps someone else is willing to pay more for it.