Doing the Math ~ Choosing between fixed and variable rate mortgages

By Calum Ross

Year over year, perhaps the most contested issue in the mortgage market is the age-old decision of choosing between a fixed and variable rate mortgage. Hundreds of thousands of dollars of personal financial research dollars has been poured into making the case and giving the final decisive pearl of wisdom to consumers. Here is some wisdom that will work in any set of market conditions, and perhaps most importantly, will certainly help you determine the best choice for your own personal risk tolerance and financial circumstances.

Anyone who suggests you should go with either a fixed or variable rate mortgage without first taking the time to understand your own long term goals, the longer term picture of your cash flow and your own individual risk tolerance is a financial professional you should be very wary of. I have more than seven years of post secondary education, I have worked directly in the global treasury operations of one of Canada’s big five banks, and the first thing I have to tell you is that anyone who pretends to know what is going to happen with long term interest rates is either delusional or has a grossly exaggerated opinion of themselves.

“Anyone who pretends to know what is going to
happen with long term interest rates is either
delusional or has a grossly exaggerated opinion
of themselves.”

At any given time, Canada’s capital markets represent about three per cent or less of global capital markets and our economy is heavily reliant on exports to our key trading partners. What this means for Canadians and Canadian mortgage consumers is that no matter how closely we watch our own economy, we will always be subject to changes in our capital markets (debt and equity markets) as a result of shocks to the global system and particularly shocks to our key trading partner – the United States of America.

What this means to the fixed versus variable decision is this: At any given time there is a set spread between the difference in the discounted five-year fixed rate (the most popular long-term mortgage product) and the discounted variable rate product. Depending on what is happening, this spread increases and decreases in response to movements in the overnight lending rate set by the Bank of Canada and the Government of Canada bond market. This difference in rate represents the premium that mortgage consumers have to pay for the peace of mind that longer term fixed mortgage offers. Conversely, the difference in savings for going variable represents the reward for taking on the extra risk of not locking in your rate and protecting you against future potentially unfavourable risk movements.

In reality, the only thing a longerterm fixed mortgage does give you is a guarantee against your rate and subsequently your payment moving for a longer period. In fact, it is essentially an insurance premium that insures you against interest rate risk, and like all insurance premiums, they change and are more or less valuable to different market participants.

The difference between this longer term fixed rate and the variable rates, rise and fall in different market conditions. Traditionally, the difference between short and long-term rates is highest when inflation is high – at some of these points in time, the difference was more than two per cent. When inflation is extraordinarily low, the difference in these two rates has been as low as less than 0.5 per cent. Regardless of what the difference in the two rates is, the thing we know for certain is the relative cost-benefit analysis really comes down to your own tolerance for risk and the math of how much you ultimately pay (cost) for that piece of mind, or stand to gain (save) from taking the extra risk.

Only you can ultimately gauge that decision, but if you want to do the math, then it is fairly simple. All you need to do is multiply the mortgage balance you have or were considering taking between the difference in the fixed versus variable.

As an example – if you have a $100,000 mortgage and the difference between a competitive fixed rate mortgage and a variable rate mortgage is one per cent then the additional premium per year for that peace of mind is $1,000 or $100,0000 x (the difference in interest rates). If you take a look at the math based on this equation and the cost seems reasonable, you are likely psychologically suited for a longer term fixed mortgage. If it seems expensive to you, then you are likely a good candidate for a variable rate mortgage.

One final caveat: there is no amount of financial gain that ever warrants putting yourself under financial duress. When it comes to mortgage or financial decisions, the wise consumer does not take on more risk than they can financially handle. The implication – if you can’t afford an upswing in rates then going variable is not a sound decision in any economy.

Source: New Condo Guide