The Variable Rate Advantage

                     or To Fix or Not to Fix (your mortgage rate)

One has a fixed rate mortgage, the other is Matt Damon.

Throughout the years, most people have fallen into two groups; those that understand mortgages and those that let their banker figure it out for them.

Okay, there's also that group that just does what their parents tell them to do. 

Then there's that other group that have no idea what mortgage is and what it entails (let's call them 'kids today'). 

So, four groups but I digress.

Let's focus on the first two. 

Nowadays, thanks to the internet and the continuing increase of personal debt, people are doing more research into how they can make their dollar stretch farther. Ironically tv shows, websites, travelling circuses have been set up to help people take control of their debt in between advertisements for flat screen TVs, mobile phones and 0% down brand new cars and limited edition paperback do-it-yourself manuals.

One of the biggest monthly debts people have or will have is their mortgage/rent. It's simply the cost of living and very difficult to negotiate. You can't just call up your landlord and tell them that you have decided to pay only $200 a month now in rent

and I want to enter through a door!

 If you are living in a rent situation, you are in a good position to not have to worry about mortgages. You will pay a flat fee no matter what happens in the money markets. That is basically the same as a Fixed or Conventional Rate Mortgage. You don't have to be concerned what the financial markets are doing, in theory. If you are in a fixed rental situation, you are legally impervious to major rent increases. Fixed mortgage payments are the same. You are under contract to pay X amount of dollars per month, no matter who the chief economic officer is of the country or your views on what's on TV.

Fixed Rate Mortgages, a popular option, makes up nearly 2/3's of the mortgage industry. It's by far the choice of most banks as from a historical perspective; it guarantees them a bigger return for their loan. Which is why in today’s mortgage market you will rarely ever hear a bank offer you a variable rate mortgage because variable rate mortgages follow the market fluctuations. 

It is what it is; a rate that is variable, meaning it changes as the lender's Prime Rate changes. In Canada, the Prime Rate can be adjusted eight times a year which happens after the Bank of Canada announces its key interest rate. I say 'can be' as, despite many, many, many predictions over the last two years, the key interest rate remains at an all-time low 1%. Canadian financial institutions then base their Prime Rate (the rate they charge their best customers) on that 1%.

Simply put, the Bank of Canada adjusts the Prime Rate depending on the state of the overall Canadian economy and inflation rate. When inflation is high, the BoC raises the Prime Rate to make borrowing money more expensive. When inflation is low, the BoC keeps the Prime Rate low to stimulate the economy and make it attractive for companies or people or countries to borrow money. But that's a whole other story... 

So, let's say I have suggested a variable rate mortgage your $100,000 real estate purchase that is the current Prime Rate (3%) - .4% (2.6%) over 5 years. The catch is that your mortgage payment could increase depending if the Bank of Canada increases that key interest rate. You gaze into your economic crystal ball and are pessimistic. You don’t see sudden economic prosperity coming to Canada overnight. You agree with those experts that say raising the interest rate will severely shock the economy (think of a rising interest rate as the brakes to stopping economic development) and decide that you are comfortable with any slight changes that may happen considering the money you will save in interest. 

You accept the Variable rate.

Your neighbour, who happens to be using his bank due to being a loyal customer there for years and isn't interested in the 'hassle' of talking with a Mortgage Broker has signed on to a $100,000 mortgage for the Fixed Rate of 3.5% over 5 years. His banker has convinced him that 3.5% is a good deal because in a couple of years, the rate could be as high as 5% and wouldn't he be glad he won't have to pay that interest rate if it were to happen?  

So who's paying less? 

A fixed mortgage won't rock the boat; Variable is all business with a little bit of party. 

Right off the start, it's pretty obvious that I've picked you to have the variable rate that you will be paying less. I want to make you the hero in this story, not the boring guy who like his macaroni plain. Historically, someone with a Variable Rate always pays less. After all, their mortgage rate is lower right off the get-go; 2.6% vs. 3.5%.   

Let's break down the advantage by the numbers. 

Calculators are amazing these days.

For someone paying a Fixed Rate Mortgage:

$100,000 at 3.5% over 20 years = $138,879 in total payments IF he was to pay only 3.5% over 20 years. But we are going with a 5 year term. Your neighbour has fixed monthly payments of 578.66. After paying $34,719 in payments over 60 months he has only actually paid $18,914 of the principal loan. He still owes $81,086 of the mortgage amount (trust me, i'm using a calculator for this) and at which time it will be time to renew or renegotiate the mortgage for the amount owing.

Now, for someone paying Variable Rate:

$100,000 at 2.6% with a 5 year term. For the purposes of this exercise and the recent (Canadian) announcement of the continued interest rate hold, let's assume a o% increase for the first 2 years. After the next federal election, the Year 3 Prime Rate has increased .2%. Year 4 it grows another .2% and by Year 5, with inflation rising on news of $10,000 tax rebates for everyone (hey, it’s my scenario) it increases another .6%, in total a 1% increase over 5 years.  

Because it's ‘variable rate’, there's more math involved on the part of the lender to figure out what your new balance will be. Remember this is a completely hypothetical guesstimate for ease of this example. 

First, a loan of $100,000 @ 2.6% over 20 years = $128,185 (that’s already a savings of nearly $10,000 in interest compared to the fixed rate!).

  

By year;

                           (principal owing)

1st year (2.6%)      96131               payments   534.10

2nd year (2.6%)     92161               payments   534.10

3rd year (2.8%)     87861                payments   567.58

4th year (3%)        83510                payments   575.96 

5th year (3.6%)     79224                payments   600.01

In Summary;

By the end of a 5 year term;

Variable Rate mortgages will have paid nearly $21,000 off their principal. 

Fixed Rate mortgages will have paid just over $19,000 off their principal.

Fixed Rate will have spent $35,024 in mortgage payments.

Variable Rate will have spent $33,741 in mortgage payments.

PLUS Variable Rate Mortgagees saved nearly $50 a month for the first 24 months for a $1200 savings! 

So not only does a variable rate pay off more of your principal in the long term, it also saves you more in the short term. But again, it's not something most bankers are going to advocate. Ask your local mortgage broker for more details and see if a variable rate mortgage is the right thing for you.

 

do these suspenders and belt make me look smarter?  

Pls feel free to add any comments/questions below.