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Tuesday, April 29, 2008

Mortgage Advice - Go Variable

I have often wondered why so many people opt for 5 year fixed rate mortgages. Yes, they want the security of knowing exactly what their payments are going to be over those 5 years but they sure are paying through the nose for that security. As I write this, interest rates on a 5 year closed variable rate mortgage are 4.15%. Take that instead to a fixed 5 year closed mortgage and you are looking at 5.65% or more. Yes, a whole extra 1.5 points for the privilege of knowing what your payments are going to be over those 5 years. Essentially you are buying an insurance product. 1.5/4.15 x 100 = 36% . Yes, you get to pay 36% more interest in order to cover your "insurance" premium. So just how much is that? On a $200,000 mortgage, that 1.5% extra interest = $3000 per year. Over 5 years, that is close to an additional $15,000 assuming interest rates don't change and ignoring principal reduction. You're effectively giving up a new car every five years!!!

But of course interest rates don't stay unchanged, they could go shooting way up. Sure, but they could also go down too. So why does anybody go with the 5 year fixed? Simple, because somebody convinced them that they could get screwed and not be able to make their mortgage payments if interest rates go shooting up. Fear can be quite the motivator. But there is a feature of most variable rate mortgages that they don't want you to know about. Most of them allow you to convert them to a fixed rate mortgage at any time. So if interest rates start to rise and your payments on your variable rate mortgage jump up and you get all scared, then simply convert it to fixed. But there is another tactic that I'd rather you use.

Take out a variable rate five year mortgage, but at the same time ask them to tell you what your payments would have been if you had've taken out the five year fixed. You are effectively going to insure yourself with this scheme. Take the difference between your mortgage payments and the hypothetical fixed rate payment, and place that amount into a savings account. In fact, place it into a new Canadian tax free saving account (TFSA) that becomes available to us taxpayers on Jan. 1, 2009. This amount, of course, depends on the size of your mortgage and the difference between the variable and fixed mortgage rates, but could easily be around $125 per month for many of you. As interest rates fluctuate, so will your payments into this account. If your payments ever reach the point where they exceed the hypothetical five year fixed payments, then simply draw money out of the account to cover the difference. At the end of the five years, when your mortgage now needs to be renewed, simply liquidate your savings account and put that extra money down on the mortgage. Alternately you could use this money to top up your RRSP and put the tax refund against the mortgage. But in either case you should be immensely better off by using this do-it-yourself approach to a "five year fixed" mortgage rather than the bank's conventional way of simply charging you a much higher fixed rate.

9 comments:

Michael James said...

I got a three-year term for my first mortgage, but went variable to get the lowest possible rate after that. Your strategy sounds interesting as a form of self-insurance.

Is the spread of 1.5% between a 5-year term and a variable rate typical? I haven't looked at this for a while. I know that this gap varies, but it seems to me that the expected amount of savings would be related to the typical gap rather than the gap today. The theory being that the size of this gap is predictive of changes in short-term interest rates. This theory may be false, though -- I've never checked it.

Jim Somerville said...

The mathematician in me would want to number crunch a whole slew of sliding five year windows across, say, the last decade, beginning every month. This would be driven by tables of variable rate data, and the calculation would be to produce an effective equivalent five year fixed rate. Then compare that with the actual five year fixed rates at the beginning of each interval. Simply publishing this data would likely force the gap lower as the reality of the "insurance premium" would be now visible to the public.

In today's environment where rates are trending down or at least are somewhat stable, the risk of rates flying upward looks low, at least to me. Also, the baby boomers are mostly done with borrowing and now have savings that are seeking low risk returns, so the demand for borrowed money looks to stay quite low for the forseeable future anyway. Is a 36% interest rate premium justified? I don't think so. Is it historically this large? Again, I'd have to dig up the data and run the numbers.

Adil Burney said...

Nice site!

Jim Somerville said...

I just obtained some real numbers. They are from the Bank of Canada and represent conventional fixed term mortgages at the chartered banks. There is no data for variable rate mortgages.

Over the last ten years, the average 1 year mortgage fixed rate is 6.05% and the average 5 year fixed rate is 6.97%. Let's just call the difference 1%. Variable rate mortgages are typically less than 1 year fixed, so an historic spread of 1.5% between variable and five year fixed is certainly believable.

Michael James said...

I assume that the Bank of Canada numbers are based on actual mortgages as opposed to advertised rates by various banks. Your 1.5% figure is definitely plausible historically. I'd like to think that it will come down as the mortgage business gets more competitive, but that may be wishful thinking.

http://briangarson.com said...

Michael I have to thank you for this post, I was at a Mortgage broker last night discussing my options for a mortgage on my first home, which I purchased in January, and closes at the end of the summer. My initial thoughts were 5 year fixed, but after meeting with the broker I came to the same conclusion as you've posted here 5 year variable mortgage, and just watch the markets.

however instead of depositing the extra money into a TFSA or somewhere else, I'm simply going to be overpaying my bi-weekly payments, to what my 5 year fixed rate would have been over 20 years to hopefully pay it off a little bit more. The interest saved could do some good work being added on in the form of principal payment every month. I figure if the rates do eventually go up, well at least I took advanatage while they were low and paid more of my principal down.

Anyways thanks for giving me some more confidence with my decision.

Jim Somerville said...

As long as you are already maximizing your RRSP contributions, and you can tolerate your mortgage payments potentially going up somewhat, then by all means put the extra money on the mortgage. The scheme of putting the extra money in a savings account was to buffer the individual who cannot afford their mortgage payments going up beyond the five year fixed rate.

Kathy Desjardins said...

That is such a good idea to advise the client to invest the difference between the variable and the fixed into a TFSA...when they become available. Why didn't I think of that? I almost never sell a VRM - unless the client insists! Historical data proves that VRM is always the better choice over time.

Kathy Desjardins said...
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