Fixed Vs. Variable – The Age-Old Question

Mortgage holders and homebuyers have enjoyed three years of fixed-interest rates under three per cent. As this low-rate environment continues the age-old question of whether to opt for a fixed- or variable-rate mortgage is still the most common question asked.

According to Robert McLister, mortgage planner and founder of intelliMortgage Inc., there is no simple answer. It boils down to individual clients, their personal situations and how they manage risk. “We ask a lot of questions to determine the appropriate term for a borrower, because only then can you present them options,” says McLister.

Here are some of the questions McLister explores with his clients:

  1. Can you manage a potential rate hike? According to a recent survey, 16 per cent of respondents said they would not be able to afford a 3-percentage point increase in interest rates, while roughly 27 per cent would need to review their budget. Another 26 per cent said they would be concerned, but could probably handle it. “We look at a client’s payment today, factor in amortization and make sure they can handle the potential increase, both during the term and at renewal,” he said. “If a client is set on a floating rate we also find ones with fixed payments, but a fixed payment doesn’t mean ‘risk-free’.”
  2. Do you have three months of savings put aside? Cash reserves enhance one’s ability to withstand higher rates. “The last thing you want is a soaring variable-rate at the same time as other budgetary stress, like a layoff, separation, illness, new baby or some other unforeseen expense.”
  3. Where will you be in five years? Clients who break a fixed-rate mortgage early, can face a steep interest-rate differential penalty. By contrast, terminating a regular variable-rate mortgage costs you just three months of interest. That’s a key consideration if you want refinance flexibility, may sell and rent or can’t port for some reason. In many cases, it’s more prudent to choose a three-year term.
  4. What’s the spread between a 5-year fixed and variable? The current spread is about half a percentage point, far below the long-term average. “That makes the relative cost of a fixed-rate certainty historically cheap,” McLister said. “But it also suggests that the market is expecting low rates to persist. Over the long run, variable rates have easily outperformed fixed rates, but one notable exception is when the spread is very small.” What’s the break-even point? There’s a point when a long-term fixed rate becomes cheaper than a variable rate. “Today, that would happen if prime rate shot up over three-quarters of percentage point,” McLister estimates. “If inflation becomes a threat, the Bank of Canada could easily take rates higher than that. That’s the risk.”

The choice of fixed versus variable remains a personal decision. Everyone’s circumstances are unique. If a client stays awake at night worrying about their payments increasing, then a fixed rate is the way to go. If they’re financially fit and have a shorter amortization, then a variable may be the right call. Either way, you can’t put a price on peace of mind.

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