Should I lock My Variable rate into a fixed rate Mortgage?
The age old question, one that can cause you sleepless nights. Today I want to take a deep dive and cover a few things to provide better perspective.
Understand what few people do
In order to answer this question for yourself, you need to understand what very few people do- and that is that there are essentially 2 things that you need to be looking at, Not Just One.
Many people are led to focus on just 1 thing, but there are essentially 2 bets if you will -that you make when you are choosing to go fixed vs variable.
The first thing is the interest rate – and the second, which can have much more of a significant impact on your overall costs- but it’s something that much less people consider – let alone even know about – this bet relates to mortgage penalties – but we will start with the rate component first before shifting gears..
So here we go:
So bet # 1
And sadly the only question that many borrowers ask – what is the best rate rate? Is there a rate advantage for going variable?
The reality is that the net rate difference between a 5 year fixed and a 5 year variable – no matter how significant or insignificant – means very little in the grand scheme of things.
Why am i saying this? – well, many are focused on “rate” but the reality is the thing that matters the most is the mortgage payment – because that is what comes out of our bank account at the end of every month, or two weeks if you are on a bi-weekly schedule – or every week if you are paying weekly.
Now if your mortgage broker is doing their job, they’re going to, or they would have explained the differences in policy of a variety of different lenders. Some lenders have a variable rate with a static payment – meaning that your payment would stay the same even if prime were to move up, or move down – what would shift would be the amount of the payment that goes towards interest or principal, if prime were to have gone up, more of the payment would go to interest and less to principal for example.
Since 2008, the last great recession, it took the bank of Canada until 2018 to move prime. Now if history is any indication, we are not going to be looking at any major increases to prime any time soon. and even if we do, for how long will this trend continue before it reverses back?
Now, even if we did see some increases, for every quarter point increase, the impact on your payment (assuming you have a variable rate that’s payment adjusts with prime increases) would be about 12 dollars per month for every 100 thousand dollars that you are borrowing. So for the average Canadian with a 400 thousand dollar mortgage, the payment would rise less than 50 dollars per month (keep in mind also there is still some of that payment that will be going towards your principal pay down – its not all just interest).
So, if interest rates are not the be all and end all…..then what are we missing?
Well this is the second question, or bet if you will, and that is: “what happens if I break this mortgage early”? And you may expect to never break your mortgage early, in fact rarely anyone ever expects this – I know I didnt – but in reality we do…..and at a far greater rate than we think….here are a few things to consider that could potentially lead to someone having to break their mortgage ….96% of business fail inside 10 years, odds are that you are employed by a business or you own your own business. Think about that for a second, 96%…..60% of marriages fail inside 10 years. Are you engaged, just married, or well past that 10 years – whatever the case may be – life happens –
Now I don’t want to be all negative – many good things in life happen as well – like – TWINS – surprise! – work promotion – work transfers to a new province – oops – cant port that credit union mortgage from that one province to another – didn’t think about that at the time – or maybe to a smaller town- this seems to be happening a lot of late, especially with work from home becoming more of a normal thing. People are considering moving to smaller towns – and that smaller town – maybe its a rural property that you are interested in – and some lenders don’t like to lend on those – maybe your current lender – although you can port your mortgage – you cant port it to that particular property.
So – if that mortgage is broken early – and roughly 2 out of every 3 people do break their mortgage early, at and around the 33 month mark – so inside 3 years – what happens!?!?
Well, let’s talk in dollars, because dollars….well…..they leave your pocket…..or they can anyways….if you’re not paying attention….
The average Canadian mortgage today is about 400 thousand dollars as I mentioned earlier – and so on a 400 thousand dollar mortgage, with a fix rate product, roughly 33 months into it with most chartered banks and credit unions, and more and more frequently we are seeing with other types of lenders as well, the penalty would amount to about 18 thousand dollars – or 4.5% of the balance.
Percentage wise, this was the same back about 25 years ago – the interest rate differential penalty – or IRD as they are known – a lot of people say – wait a minute, my mortgage only has a 3 month interest penalty. – the fine print in 5 year fixed mortgages says – the GREATER of the 3 months interest or the INTEREST RATE DIFFERENTIAL – and interest rate differential essentially means – approximately 4.5% of the current mortgage balance.
This 4.5% number was the same in 1995, it was the same in 2018 when I first made a video about this topic and it is the same today…..In fact, I just had a penalty cross my desk which I believe was 4.7% of the mortgage balance.
SO what about the penalty on a variable rate mortgage? 99% of lenders will only charge a 3 months interest penalty at the actual interest rate that you are paying on that mortgage. Which equals to about a half of a percent of the overall balance of the mortgage.
So that 400 thousand dollar mortgage, if you had a variable rate, you would only pay a 2 thousand dollar penalty to break it early.
So now, what kind of risk factors are we talking about – that is a 16 thousand dollar difference – or in other words, a 16 thousand dollar bet that someone is making, without even realizing it.
When you take a 5 year fixed mortgage, especially with a major lender without really thinking things all the way through – like what kind of changes can happen in my life – you’re basically placing a 16 thousand dollar bet that you’re going to make it through the full 5 years of that mortgage term – and in some cases, even if you are breaking this mortgage a MONTH early, a week early, a even a DAY early, you are STILL triggering this massive interest rate differential calculation – so DONT BE FOCUSED on JUST RATE – that is just ONE thing.
Now lets flip back to rates, are we in a rising rate environment? Well we seemed like we were in 2018 – and the short answer would be, it doesn’t matter – but lets play through this and lets say that the prime rate were to increase 1% over the next year, and 1% the year after that – which seems to be extremely unlikely given the most recent history – when it took a decade for prime to jump back up (not even to normal levels) why should we expect any different after the hammering our economy took this time around too?
Now no matter how unlikely this scenario – lets take this one step further – for 2 out of 3 clients who have broken that mortgage at 33 months they’re ahead by thousands of dollars anyway – even if prime were to increase – now if prime were to stay steady – well then they’re ahead by even more – probably tens of thousands of dollars.
People fear rates rising – people feel losing a few hundred dollars this year and next year, even if prime increases, maybe a few THOUSAND dollars – even though there are many indications that prime will not increase on the level they are saying – at least not “forever” – yet somehow people don’t fear triggering a 16 thousand dollar penalty – and this is in essence a double whammy because historically the 5 year fixed has you paying more interest as well as a higher penalty. So you pay more interest to pay a higher penalty
What we should really be fearing, is the unknown, and that is what all of us face….and really when it comes to mortgages we really should not be fearing anything, because there should be no uncertainty, there should be no ambiguity, there should be no unknown….don’t get caught 3 years from now…..ask questions, ask your broker.