*Here’s part 5 of my 10 step series on mortgages here at Financial Uproar every Wednesday. Every step of the process will be covered from the application to qualifying to tips and tricks to save money on your mortgage and everything in between. To read all of these just click on the category Mortgage Basics.*

Like every good question, the fixed vs. variable rate mortgage is a debate with merit on both sides. While variable rate mortgages have traditionally been a money saver compared their fixed rate counterparts, sometimes the benefits of a certainty that a fixed rate offers will trump any cost savings offered by variable rates. It is, like many decisions in personal finance, a strictly personal decision.

How does someone decide whether to go with a fixed or variable rate? There are numerous factors that could factor into the decision.

## Advantages of Variable Rate Mortgages

Traditionally, borrowers have been better off if they took a variable rate mortgage. According to mortgage guru Moshe Milevsky in a study published in 2001, variable rate mortgages came out ahead of their fixed rate counterparts 88% of the time since 1950. On a house worth hundreds of thousands of dollars these savings can be substantial, especially when expressed over 20 or more years. Someone can save tens of thousands by taking out a variable rate mortgage.

When I bought my house in mid 2008, I took out a variable rate mortgage. By the time mortgage rates hit their lows in mid 2009 I had kept my payment fairly consistent while cutting my amortization down from 25 years to just a hair over 17 years. Because my interest rate was so low I was making substantially more progress on principle.

## Advantages of Fixed Rate Mortgages

Advocates of fixed rate mortgages often cite the stability of the payment as the biggest advantage of having a fixed rate and they are absolutely correct. The borrowers who take on the standard 5 year fixed loan take comfort that their payment will be the same every month, no matter what interest rates do. For them, taking out the fixed rate hedges their interest rate risk. They feel secure with their payment and to them, that is worth every penny in excess interest they may pay.

## What About Now? Fixed or Variable?

As I write this, borrowers can get a five year fixed mortgage for 3.99% while a variable rate can be had for prime – .70%. (2.30%) Typically the spread between fixed and variable tends to sit right around 1.5%.

The question a borrower has to ask themselves is this: Over the next 3 years or so, will rates increase by more than 2-3%? If the economy recovers and the dollar remains strong in Canada, this is a distinct possibility. Also, one has to remember that prime has historically sat in the 5-7% range in Canada, barring the crazy heights of the 80s and the lows of the last couple of years. So if prime returns to a more normal level by 2012 or so then any advantage variable may have had would be largely gone.

Saying all of that, one could probably make an equally convincing argument that mortgage rates won’t climb that much by 2012-13. Economic growth is sluggish, inflation is tame and the central bank has no real short term incentive to tighten rates. Predicting interest rates will always be a sucker’s bet, the fixed rate camp would say, so why try?

## Can’t Make Up Your Mind?

Then why not try one of those hybrid products that are half variable rate and half fixed rate? Another option is to get a fixed rate, but for a shorter time frame- say 1 to 2 years. These rates will be closer to prime, giving the borrower a lower rate, as well as locked in, giving the borrower security. The only downfall to this plan is having to renew every 1 to 2 years, a process that can be time consuming if you take the time to shop around.

Ultimately, saving money should be the borrower’s chief concern, and typically variable rates end up cheaper than fixed. If you’re so risk adverse that a variable rate will add stress to your life, then fixed is the way to go. Like many personal finance decisions, this one can go deeper than the numbers.

I never understood the argument that you will always know what your payment will be with a fixed rate. Your payment doesn’t change with a variable rate either, just the principle and interest if the rate fluctuates.

The other argument for fixed rates that baffles me is the ‘sleep at night’ factor. Really, do you sleep better knowing you’re paying 1.5 to 2.0 percent more than someone with a variable rate mortgage?

You are right, you have to look at the spread between the variable and fixed rates and ask yourself where you see interest rates going over 5 years. I would also argue, at what pace? You might come out ahead for 2.5 years before the gap is completely closed, and then be paying more for the last half of your term, but the variable would still likely win out.

It depends on what the borrower negotiates with the lender. My variable rate started off with a payment that fluctuated with interest rates. I reset it at the maximum payment they'd allow, which let me make significant progress on it. A lot of people don't have room in their budgets to stomach large increases in payments, and they want to maintain their amortization schedule.

People are willing to pay a premium for security. I wouldn't do it, you wouldn't do it, yet millions do, including Mark. If inflation comes like crazy and the Bank of Canada jacks rates quickly, maybe we'll be the suckers.

Nice post.

Like Echo, I never understood the 'what you will pay argument' for fixed over variable, but I can tell you why my wife and I went fixed last December when we bought our house:

Within in the next 5 years, rates will go up at least 2%. They have to, as you have said, re; prime. If not, most families in this country will be set up for bankruptcy. Personal debt loads will be a colossal mess. Our 5-year fixed is below 3.5%.

Cheers man,

Mark

Great Post.

I have a hybrid mortgage back in 2008 with the fixed rate at 5.8% and variable at prime minus 0.65%. My company subsides the fixed portion by 40%.

I have doubled up and accelerated payments to try to pay off the mortgage sooner. I have a lump sum amount that I would like to put towards the mortgage and am not sure whether it is better to put it against the fixed portion or the variable portion.

I realize that the variable rate will go up eventually but am paying more in interest on the fixed amount.

Any advice would be appreciated.

So if I do the math right, the fixed portion costs you 3.48% a year, while you’re paying 2.35% for a variable. For the variable portion to cost more than the fixed, you’ll need 5 rate increases by the BOC. I think that’ll take a while. So I’d pay the lump sum to the fixed part.

Hope I helped!