What to Consider When Selecting a Variable Rate Mortgage

Fixed or Variable Rate Mortgage

The debate on whether it’s better to get a fixed or variable rate mortgage never seems to end. This conversation reminds me of the RRSP vs. TFSA debate. In this post, I will tackle the topic to help you better determine which option is better by using a hypothetical example based on today’s market condition.

Case Study

A couple named Turkey and Greece is looking to buy their dream home. They have found a condo they want to purchase with a mortgage loan of $400,000. Here are the two mortgage rate options offered by their lender.

  • 5-year insured fixed-rate mortgage at 3.64% with a 25-year amortization
  • 5-year insured variable rate mortgage at P-1.15 (Prime rate at the time of writing this is 3.20)

To complete this example, we need to assume what the Bank of Canada will do with increasing interest rates. As I write this, we are in a high inflationary environment, and the Bank of Canada has indicated inflation needs to be brought back in line. One of the Bank of Canada‘s mandates is to keep inflation low, stable, and predictable. Given we are in a high inflation environment, I will compare two scenarios. One scenario will have the Bank of Canada increase its rate by 50BPS, while the second will assume a 100BPS during the mortgage term.

Which Mortgage Type Is Better; Fixed Or Variable?

Scenario One- 100BPS Increase

Fixed Variable
5 Years Year 1 Year 2 Year 3 Year 4 Year 5
Mortgage Rate 3.64% 2.05% 3.05% 4.05% 5.05% 6.05%
Monthly Mortgage Payment $2,026.75 $1,703.47 $1,895.80 $2,091.69 $2,289.83 $2,489.04
Outstanding Balance at Term End $345,999.47 $387,608.04 $376,451.99 $366,285.21 $356,899.96 $348,118.84
Total Principal Paid at Term End $54,000.53 $51,881.16
Total Interest Paid at Term End $67,604.72 $73,756.80
Total Savings for Choosing Variable Rate

($6,152.08)

 

Scenario Two-50BPS Increase

Fixed Variable
5 Years Year 1 Year 2 Year 3 Year 4 Year 5
Mortgage Rate 3.64% 2.05% 2.55% 3.05% 3.55% 4.05%
Monthly Mortgage Payment $2,026.75 $1,703.47 $1,798.21 $1,892.13 $1,984.92 $2,076.30
Outstanding Balance at Term End $345,999.47 $387,608.04 $375,723.85 $364,247.19 $353,085.22 $342,150.63
Total Principal Paid at Term End $54,000.53 $57,849.37
Total Interest Paid at Term End $67,604.72 $55,611.01
Total Savings for Choosing Variable Rate

$11,993.70

 

Based on the chart above, if the Bank of Canada does an aggressive yearly increase of 100BPS and Turkey and Greece pick a variable rate option, they would pay $6,152.08 more in interest costs. If the increase is lower at 50BPS, they will save $11,993.70 in interest cost over the mortgage term by going with a variable rate mortgage.

3 Things to Know Before Getting a Variable Rate Mortgage

 

Interest rate spread

The interest rate spread refers to the discount amount offered on the variable rate. The higher the spread, the better the chances of coming out ahead of the fixed-rate mortgage. In the example above, the spread was a 1.15% discount on the prime rate. As a result of this spread, the variable rate did not exceed the fixed rate until the 3rd and 5th years, respectively, based on the scenarios used. You want a large spread, which will give you some cushion for potential rate increases.

Amount and speed of Increases from the Bank of Canada

The second thing you need to consider is the speed and rate at which the Bank of Canada is likely to increase its prime rate. You need to have a general sense of how the economy is doing and if the Bank of Canada is likely to use its tool to cool or stimulate the economy. Suppose the economy is doing exceptionally well or inflation is on the high side; in that case, the Bank of Canada is likely to increase its prime rate. How quickly it does this will depend on how hot the economy is or if inflation is running out of control. If the economy is sluggish or flat, the Bank of Canada might opt to reduce its prime rate to try and kick start economic activity.

The speed and pace at which the Bank of Canada will increase or decrease its prime rate can be hard to determine as no one knows what the future hold. But you need to consider how quickly the Bank of Canada is likely to raise rates and the speed they will try and move the needle each year. If they do it slowly and have a large spread, you will likely come out ahead of a fixed-rate mortgage.

Your capacity and willingness to handle fluctuating payments

Sometimes people can select a variable rate because they want a lower payment to afford the mortgage payment. You want to avoid choosing variable-rate mortgages if you have affordability concerns. A variable-rate mortgage is best for someone who can handle payment shock, not for someone who wants the lowest payment but cannot handle a payment shock. It doesn’t matter if you have a large spread as you can’t afford to have your payment increase. In the 100BPS example, the variable payment goes up each year after year one, and by year five, the variable monthly payment is $462.29 more than the fixed-rate mortgage.

To conclude, it’s possible to save money by selecting a variable-rate mortgage. The key to success with variable rate mortgages is to ensure you have the financial and risk profile to handle payment increases. If keeping your payment constant throughout your term is extremely important to you, then a variable rate mortgage might not be the best option, even if it might save you more money. If you decide to go with a variable rate, you should first get a sense of where the general economy is. Spend some time understanding where inflation is and if the Bank of Canada is likely to want to increase the rate quickly during your mortgage term. You should also select a mortgage product that enables you to lock into a fixed-rate mortgage if you wish or require to. The most important thing for you to know is to select an option that you are likely to stick to see the full benefit.

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