Interest rates are far from being an obvious issue; we take a chance and venture a guess on what’s going to happen next, but in most cases, variable mortgage rates will be the right choice.
Indeed, historically variable rates have been lower than fixed rates. A variable rate would especially be beneficial if a decrease in rates can be anticipated or even if rates remained relatively stable.
However, a variable rate will not benefit you if a rate increase is anticipated. Thus, the fixed rate today can be lower than the variable rate in a few years.
Fixed Rate Premium
You take a certain risk with variable rates, it’s only normal to be rewarded by a lower average rate.
You can let the bank take the risk for you by choosing a fixed rate but then, you should expect to pay what we call the “fixed rate premium”. The bank charges you this premium to take on the interest rate variation risk. That’s why fixed rates are on average higher than variable rates.
Opting for a variable rate mortgage is still quite personal and also depends on your age and your risk tolerance. For one thing, younger people usually accept rate variations easier.
A Big Rate Increase is That Obvious?
These days, rates are low, probably historically low. Despite the financial crisis, banks don’t have margin to lower rates even if a rate decrease could be beneficial and stimulate the economy.
Similarly, one cannot really anticipate a significant increase in rates in the coming years given the adverse effect this might have on the fragile economy.
I’m not so sure that a huge rate increase is obvious. Some king of increase in probable though.
Our Own Experience
2002
We bought our home back in 2002. Curiously, the context was pretty much the same then. The speech was: “rates are low and they will probably go up; so lock-in a fixed rate”.
Our choice came down to a 5 year fixed rate of 6.25% or a 4% variable rate.
Because the spread was big enough, we decided to go with the variable rate but used the fixed-payment option (same payment for 5 years, principal and interest portions vary according to the variable rate). We figured out that even if rates went up, the spread in the first years could compensate a pretty big rate increase in the latter years of the 5 year term.
Rates went a bit up and down but we ended up paying an average of 2% less with the variable rate option. We saved over $11000 in five years that was applied on principal and greatly reduced our balance.
2007
Then came renewal time in 2007; same speech from financial gurus: “rates are historically low, choose a fixed rate…” We could even feel a rate increase was eminent.
After a little negotiating, we gave in to the pressure and locked-in for 5 years at 5%. The variable rate was at 4.75%. We thought the spread was not wide enough to justify the risk. This decision was probably a bit guided by emotions; we pretty much feared rising rates.
But then came the financial crisis, the market crash and rates went even lower. Variable rates went as low as 2%. In retrospect, pretty bad decision; we could have saved another $10000 in interest over 5 years; quite a hefty price to pay for some peace of mind.
Could our market-timing have been worse on that one? Then again, the fixed-variable-rate dilemma always involves some kind of guess.
In the end, against all odds, the variable rate option prevailed one more time.
2012
In 2011 or early 2012, we will renew our mortgage before the end of the 5 year term. Will we have the courage to choose the variable rate?
It looks like we’ll be able to negotiate a 5 year fixed term under 4%. In late 2010, variable rates still hover around 2.5%.
Will we opt for the variable rate to stick to our basic philosophy by making long-term choices and resisting market-timing? You’ll know in a couple months but 4% sounds pretty irresistible to me. Good old fear easily throws our principles out the window.
Minimum Spread between Variable and Fixed Rates
Even thought variable rate mortgages seem to be the right choice in the long-run, it’s less obvious when rates are low.
You still can tilt the odds in your favor by only choosing the variable rate when the spread between variable and fixed rates is wide enough.
As we saw in our personal situation, it’s not a guarantee of success but we would choose the variable rate mortgage only if the spread is 1% or more.
If the spread is less than 1%, choosing the variable rate does not seem to be worth the risk in a context where higher rates are probable.
A wide enough spread gives you a margin of safety.
Earlier Years Have More Impact
Because the principal of your mortgage is going down, earlier years have a bigger effect than latter years.
If the variable rate has a 1% starting advantage in the first period, it will take more than a 2% increase just to make things even in the second period.
Simplistic Example
Let’s suppose that we have:
Principal = $100 000, Payment = $10000,
Fixed rate = 5%, Period 1 variable rate = 4%, Period 2 variable rate = 6%
Then, we could calculate:
Fixed Rate Option
Principal after Period 1 = $100000 + 5%x$100000 - $10000 = $95000
Principal after Period 2 = $95000 + 5%x$95000 - $10000 = $89750
Variable Rate Option
Principal after Period 1 = $100000 + 4%x$100000 - $10000 = $94000
Principal after Period 2 = $94000 + 6%x$94000 - $10000 = $89640
So, the variable rate option should be better off if it can keep its advantage only a couple years.
Analyze in Term of Dollars
Because it’s difficult for most people to translate interest rate percentage in real value, you should analyze the situation in dollars instead.
A 1% difference in rates on a $200000 mortgage is really a $2000 difference for only the first year. You know how much 2000 bucks is worth. It’s much easier to understand than 1%.
Then, if we suppose a 1% average difference between fixed and variable rates, would you still willingly pay the 1% premium or about $2000 a year for your guaranteed fixed rate. With dollars the image is much clearer.
Have the Guts to Choose Variable Rates
This concludes our reflection on the fixed-variable-rate dilemma. Variable rates should prevail in the long-run.
We only hope that we will all have the guts to choose the variable option, resist market-timing and conquer our fear of rising rates. Because we know that choosing otherwise has a pretty hefty price to it.
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