I recently prepared a comparison of the two for clients. I compared a 5 year, 3.94% fixed rate to a Prime – 0.70% VRM (2.30%). In the first case I assumed prime would increase by 1/4% every 6 months, and then I prepared another set of calculations where it increased 1/4% every 3 months.
If prime increases 1/4% every 6 months, by the end of the 5 year term it would be 5.25%. This matches the highest it’s been in 10 years. On a $333K mortgage, one would save almost $4,000 with the VRM. The ending payments on the VRM remained less than the fixed rate mortgage payments throughout the term.
If one assumes prime will increase by 1/4% every 3 months, prime would be 7.75% by the end. In this case, fixed was the better option, saving close to $11,000 in 5 years. Additionally the VRM payments increased to a level that was bout 17% higher than the fixed, or roughly a 3.5% annual average.
If a borrow can’t afford any payment increases due to job, life or their financial situation, the fixed rate is likely the best option.
If not, and one believes prime will likely not exceed about 5.75% in 5 years the VRM should be considered. Otherwise take the fixed. Email me for the spreadsheets. 🙂 Randy
Moshe Milevsky on Locking Into A Fixed Rate (Canadianmortgagetrends.com)
Apart from peoples’ desire to front-run mortgage rule changes, nothing drives mortgage volumes like a rate increase, or the threat of one.
5-year fixed mortgage rates jumped 1/4 point last week. Many saw that as their cue to lock in a fixed rate.
He says, often “the public is urged to act now,” but then “a few months later something unforeseen” happens and rates fall back down.
Milevsky writes that just one year ago rates did the same thing.
Here’s a chart we put together of 5-year bond yields over the last year (government bond yields drive fixed mortgage rates).
(click to enlarge)
Had you got a $200,000 25-year-amortized mortgage in March 2010, just as rates were soaring, you would have paid a healthy premium. Suppose, for instance, that you had chosen the typical 3.94% five-year fixed at the time, and held it to today. Our calculations suggest you would have paid over $2,500 more interest than you would have in a prime – 0.50% variable (which was common at the time). That’s not exactly chump change.
But making a point based on hindsight is narrow-minded. At the time (March 2010), most analysts believed rates were starting a long-term trend higher.
The point is simply this: future rate expectations should not be the primary determinant of your chosen term. (“Future rate potential,” however, is a different matter. You do need to account for where rates might go—so you’re prepared if they do.)
Whatever the case, Milevsky warns not to “rush into home ownership because you are convinced that mortgage rates are headed-up” and that we’ll never see low rates again.
He then adds something interesting. Despite Milevsky’s research showing that variable rates have historically saved homeowners considerably more money, he says:
“If you’ve just bought a home and you have a large mortgage, relative to the home’s value, I urge you to lock-in for as long as possible.”
That’s quite unequivocal advice from a respected authority, and especially noteworthy given that Milevsky is an academic who doesn’t make public recommendations lightly.
Milevsky says highly leveraged homeowners “are now facing the probable risk that real estate prices decline and interest rates increase.” This, and “the possibility of job loss, disability or other macro factors” make someone with less equity and financial resources “the ideal candidate for a fixed rate mortgage.”
“The last thing you want to be doing is trying to renew your mortgage in a year or two from now, if rates increase and possibly the appraised value of your house has declined by 10 per cent or more.”
Milevsky, on the other hand, says he chose a variable-rate mortgage for his own home “because I can tolerate the risk and want to pay as little as possible for unnecessary insurance.”