Fixed or Variable? That is the question

[wgraham]

Here is our latest blog post....comments welcome!

To be or not to be? To fix or ride the variable rate mortgage? Many investors and home owners ask themselves this question when getting a mortgage for their home. I know this because quite frankly I get asked this question on a weekly basis and I was once asked this very question 5 times in one day! This is a hot topic!

Right now there is a large spread between the 5 year fixed rate @ 4.25ish and the 3 year variable at prime (2.25%) minus 0.25 to 0.5. To anyone selecting a mortgage that is thousands and thousands of dollars.

In the chart below I have three scenarios: Variable rate rising slowly (0.5%/year), average (0.75%/year) and high (1.25%/year)

By the graph of interest rate increases you will see that the variable rate will cross the fixed rate at some point in time in the five year period. If the area above the fixed line is less than the area below the line than go variable. If it is equal it doesn`t mater but if it is greater then go fixed.

Is it really that simple? Well yes and no. The trick is estimating how quickly the Bank of Canada will raise rates. My personal take is that Mark Carney is going to raise them on the slow to average range so we have 95% of our current mortgages in a variable product.

The other thing to consider when going variable is that rents will generally rise and fall with interest rates so you always have a spread to work with. As an investor this can be a great tool but you have to actively manage your assets!

Some interesting facts for you: most first time home buyers get a fixed rate mortgage. Everyone else typically goes variable.

Lastly, we always budget our properties for a fixed rate mortgage but then purchase a variable rate product. In our minds the fixed rate product is the worst case scenario!!

I hope this helps in choosing your next mortgage!

 

[AndyLuchies]

Hey Wade, do you think with a weak U.S. dollar, the BofC will keep the rates lower than they normally might to weaken our dollar? I wonder if this would give the variable a more favourable comparison....

 

[Thomas Beyer]

QUOTE (AndyLuchies @ May 12 2010, 08:47 PM) Hey Wade, do you think with a weak U.S. dollar, the BofC will keep the rates lower than they normally might to weaken our dollar? I wonder if this would give the variable a more favourable comparison....
indeed .. and with all that European debt Canadian interest rates will be lower longer than a bullish Mark Carney hinted only weeks ago !

As Wade suggested, unless you are a highly levered first time investor with no reserves whatsoever .. STICK WITH VARIABLE RATES !

 

[dwoychuk]

Peter actually just went over this in the REIN meeting, and the numbers were quite substantial (in favor of variable). I unfortunately don`t have the worksheet with me otherwise I would share the example that Peter gave us. All I can say is if you weren`t there for the meeting, you will definitely want to listen to that portion of the CD`s when you get them.

 

[JimWhitelaw]

Hi Wade, thanks for starting this topic. The graph you created helps to visualize rates, but the advice to calculate area above/below the fixed line doesn`t make sense to me. Not sure what you meant by that?
Anyway, this prompted me to recreate an analysis that I did a few years ago and lost somehow. What I did was modeled the three scenarios above for rising interest rates on actual payment sequences. Because the principal paydown varies over time (increasing with time), a more precise analysis of fixed vs variable will look at the total cost (P + I) paid in the various scenarios over a period of time. It`s interesting to see the result.

Here are the assumptions:

• 25 year amortization
• prime rate 2.25% (this is actually irrelevant as all other rates are relative to this)
• Fixed borrowing rate at P + 2%
• Variable rates at primeVariables rising at 0.5%, 0.75% and 1.25% annuallyPrime moves up quarterly each yearVariable loan payments increase with each prime rate changeCosts calculated per $1000 borrowed

This graph shows the total (P +I) expense over a five year period, comparing a fixed rate with the three rising rate scenarios above:


So we see that in this case, only the highest rising rate ever costs more over the 5 year period. Comparing the costs on a percentage basis, that`s even more obvious:

I also modeled a couple other scenarios:

1) What if prime moved up even faster? Here`s the analysis for annual increases of 0.75%, 1.0%, 1.5%:

Very similar to the first one. In this case, the highest increasing rate starts to cost more in the 3rd year of the loan, and the middle increase only costs more in the last year. Again, the percentage difference in total cumulative cost:

2) What annual rate of increase is required to exactly equal the cost of a fixed rate loan? Solving backward for this, we find that it`s at about 0.825% annual increase for the 5 year term.

Percentage difference is zero.

So the big takeaway for me is this: Given a typical spread of 2% between fixed and variable rates, interest rates have to increase at greater than 0.825% per year, every year for five years, before a fixed rate mortgage starts to be less expensive than a variable rate loan. That works out to a total increase of 4.25% in 5 years. So the question you want to ask is how likely is it that prime will increase by that much? Another point to keep in mind is that in all scenarios, we`re assuming the same prime +2% spread for the fixed rate, which is about the BEST available right now. This chart shows that some banks are currently quoting as high as prime + 4%! At that cost, prime would have to move steadily to over 10% in the next 5 years before a variable loan would cost more.

 

[Thomas Beyer]

QUOTE (JimWhitelaw @ May 13 2010, 02:01 AM) ...

So the big takeaway for me is this: Given a typical spread of 2% between fixed and variable rates, interest rates have to increase at greater than 0.85% per year, every year for five years, before a fixed rate mortgage starts to cost more than a variable rate loan. ..
Jim:

These are brilliant charts / answers to a frequently asked questions by many .. including my wife .. you made my day !!

 

[Shaieus]

Thanks Jim for the detailed charts. Makes more sense.

Cheers!

 

[wgraham]

QUOTE (JimWhitelaw @ May 13 2010, 02:01 AM) Hi Wade, thanks for starting this topic. The graph you created helps to visualize rates, but the advice to calculate area above/below the fixed line doesn`t make sense to me. Not sure what you meant by that?

Jim,

I think these two graphs help illustrate what I was trying to are articulate much more effectively.

I was trying say that if you took one of the variable scenarios and then shaded the area to the fixed interest line to the point in which it crossed the fixed interest rate line and then did the same for the time past that intersection and compared those two shaded areas you would have an answer. In other words.....is there more orange above the line than below the line......I still don`t think this explanation is as good as your two graphs

As for rising interest rates, I think Thomas hit the nail on the head.....we are not going anywhere quickly. We will basically fallow the lead of the US unless we want to inflate our dollar and kill exports.

Happy investing!

 

[Millions]

With this in mind, does anyone think its worthwhile to change my fixed rate at 4.2% to a variable by paying a $3000 penalty?

 

[wgraham]

QUOTE (Millions @ May 13 2010, 03:13 PM) With this in mind, does anyone think its worthwhile to change my fixed rate at 4.2% to a variable by paying a $3000 penalty?

You have to answer a few questions to answer that one.

What would your new rate be?
and
How long are you going to hold the mortgage for?

my gut says that it is probably worth it if you are in it for the long hall. Some times you can get them to lower the penalty if you keep it in the same institution or get the new institution to pay the penalty or a portion of it. Never hurts to ask.

 

[DonCampbell]

Nice Work All. What is most encouraging is the fact that while the `masses` are focusing solely on the `potential paymet increases` sophisticated investors like yourselves are analyzing the `real cost of consistency.`

Peter`s presentation at the Alberta Workshops (along with Collin Bruce`s analysis handout) really put it all in perspective that have ALL the facts in front of you allows you to cleary see the bottom line choice.

It isn`t just about the payment - it`s about what makes up that payment that really and truly matters.

Great discussion!

 

[JimWhitelaw]

Wow, those charts are ginormous! Sorry about the huge graphics, I`ll see about resizing those to something a little friendlier. A couple people have asked me about the spreadsheet I used for this analysis. It is done in Google Docs online, here is the link for you to view/copy the spreadsheet. Feel free to use it as you wish. If you publish it, I`d appreciate an attribution.

http://spreadsheets.google.com/ccc?key=0Aq...xUN2c&hl=en

I welcome any input to improve the accuracy of the analysis. It`s interesting to play with - plug in some really high prime rates - (20% anyone?) and you`ll see that the out come is essentially exactly the same.

I don`t know much about long-term historical interest rate changes in Canada - have we ever seen a 5-year period where rates increased by more than 4.25%?

 

[Millions]

QUOTE (wgraham @ May 13 2010, 03:22 PM) You have to answer a few questions to answer that one.

What would your new rate be?
and
How long are you going to hold the mortgage for?

my gut says that it is probably worth it if you are in it for the long hall. Some times you can get them to lower the penalty if you keep it in the same institution or get the new institution to pay the penalty or a portion of it. Never hurts to ask.


They are going to get back to me on rate. She said its 2.25% but will see if she can get me prime -.04. This would actually break me even on a condo for the time-being.....hmmm

 

[Millions]

QUOTE (wgraham @ May 13 2010, 03:22 PM) You have to answer a few questions to answer that one.

What would your new rate be?
and
How long are you going to hold the mortgage for?

my gut says that it is probably worth it if you are in it for the long hall. Some times you can get them to lower the penalty if you keep it in the same institution or get the new institution to pay the penalty or a portion of it. Never hurts to ask.


They are going to get back to me on rate. She said its 2.25% but will see if she can get me prime -.04. This would actually break me even on a condo for the time-being.....hmmm

 

[bizaro86]

QUOTE (JimWhitelaw @ May 13 2010, 04:06 PM)
I don't know much about long-term historical interest rate changes in Canada - have we ever seen a 5-year period where rates increased by more than 4.25%?




The bank of Canada posts historical Canadian interest rates. Their chart for prime is here:



http://www.bankofcanada.ca/pdf/annual_page...ge50_page51.pdf



There have been 5 year periods in the past where going variable has been the better choice, I outlined one of them here.



http://myreinspace.com/public_forums/General_Discussion/61-16428-interest_rates_to_rise.html



Obviously rates don't move up in a linear fashion, ie 0.825% per year, the pattern is more random than that. But they have moved up more than 4.25% in a five year period.



For example, from the link above, prime in June 1977 was 8.25%. Five years later, in June 1982 it was 18.25%, so it went up 10% in those five years. And for a while during those five years, it was 20% plus.

Other examples:

From April of 1973 to April of 1974 prime went up 4%, from 6.5%, to 10.5%.

From March of 1987 to March of 1990, prime went up 5.5%, from 8.75% to 14.25%.



So while your analysis is correct in that it is unlikely for variable to more expensive than fixed, as it requires a large and quick jump in prime, it is not impossible.



I appreciate the charts created by others and posted here, as it give all of us a chance to make an informed decision based on analysis. Hopefully this provides some historical information to help with those decisions. I truly believe we should all be making informed and rational decisions based on facts and analysis rather than emotion (I'll fix to protect me from rates going up) or rhetoric (I heard that variable is cheaper). It makes sense to me to consider the facts and make your own decision.



Michael

 

[greg12]

Great stuff everyone! I agree with Michael that the key is always in the assumptions. With the numerous interrelated moving parts of today`s global economy, an `exaggeration` of any one of the assumptions stated herein can change the results. For example, I remember in 2007, when variable rates were actually higher than fixed. If the stock market goes down, then fixed rates are sure to follow. And some believe that the big crash of the stock market is STILL coming.

QUOTE Here are the assumptions:

• 25 year amortization
• prime rate 2.25% (this is actually irrelevant as all other rates are relative to this)
• Fixed borrowing rate at P + 2%
• Variable rates at primeVariables rising at 0.5%, 0.75% and 1.25% annuallyPrime moves up quarterly each yearVariable loan payments increase with each prime rate changeCosts calculated per $1000 borrowed

 

[housingrental]

The road ahead to 2015 (From my biased view point):
Marginally higher fixed mortgagees rates on offer.
Fixed or variable will likely perform similar with slight advantage to variable.
Stagnation or marginal declines in housing price in most markets for sfh
In most Ontario markets multi-family will under-perform SFH.
Western Canada will fare the worst.

 

[wgraham]

Here is a BNN video with Don talking about fixed and variable mortgages....fits nicely in with this thread. Enjoy!

Don on BNN

 

[koop]

QUOTE (wgraham @ May 18 2010, 12:54 PM) Here is a BNN video with Don talking about fixed and variable mortgages....fits nicely in with this thread. Enjoy!

Don on BNN

Preach it Don!

I have the papers at home for my mortgage renewal, variable prime -.5%. Keeping the payments the same and going to the lower interest rate.