Fixed vs Variable Rate Mortgage

Fixed vs Variable Rate Mortgage

 

We’ll start with some explanation of how the banks come up with fixed rates and variable rates. How Bank of Canada’s monetary policies affect those rates. If you’re just interested in comparisons, skip to the end to see a simulated comparison using real rates since 2006.

 

Fixed-Rate Mortgages

 

Fixed-Rate Mortgages simply let you “lock-in” a predetermined rate, typically for 5 years.

Its rate directly correlates with the 10-year treasury note yield. Bond yield is the return an investor realizes on a bond.

 

Graph 1: 5YR Fixed Rate Mortgages vs 10YR Treasury Yield

 

Graph 1 shows the 5-year fixed-rate mortgage closely matched the 10-yr Bank of Canada bond yields in the last 15 years.

 

Bond yields are a function of the federal reserve’s monetary policies, its coupon payment and its market price.

 

A bond’s coupon payment is locked in at its inception. For example, if a bond pays $20 when it was first created, it will continuously pay $20 until it’s maturity. That never changes, hence why they’re also called “fixed-income” securities.

 

Its market price is affected by the central bank’s federal funds rate. When the interest rate rises, existing bonds with lower coupon payment become less attractive, driving the bond price downwards. The vice versa is also true, when the interest rate goes down, older bonds with higher coupon payment become more attractive, and their prices rise.

 

How does any of this translate into mortgage rates? If you look at the last 15 years the fixed-rate mortgage did not completely match the bond yields - it never dipped below 2% even with the yield at historical lows. What this means is that even with yield going to 0%, lenders will hold fix-rate to about 2%.

 

As of June 2020, the Fed has stated that they are not willing to raise rates through 2021. So you can expect your fixed-rate mortgages to be around 2%

 

Variable Rate Mortgages

 

If you have a variable rate mortgage, the amount of interest you’re charged is tied to the overnight rate. Financial institutions pass on any increase in the rate to consumers almost immediately.

 

Variable rates are much easier to understand. Lenders take this overnight rate, add a percentage to it, and the sum is the prime rate. Prime rate is typically the rate lenders advertise.

 

Currently, the overnight rate is at 0.25%. BoC changes this rate as a tool to control inflation, a target of 2%. BoC uses eight fixed dates throughout the year to announce their plan regarding this rate.

 

Graph 2: Best 5YR Variable Mortgage rate, Prime rate and Overnight rate

 

Graph 2 shows that over the past 15 years variable rates have stayed more or less around 2%.

 

TLDR; So which one is better?

 

I did a quick simulated comparison of a $600K mortgage started in 2006 using real rates. In Graph 3 (see below), the bars represent total interest paid during the 15 years of the mortgage. Blue bars represent fixed rates and red bars represent variable rates.

 

Since 2006, fixed rate mortgage rates consistently outpaced variable rates. If you picked and stayed with variable rates, you would have saved about $60,000 at the end of the 15 year period.

 

This doesn’t mean variable rates are better than fixed rates. The benefit of fixed rate is that during the mortgage term (5 years or 10 years), you won’t have to worry about any monthly payment increases. Fixed rates lets you plan exactly how much you will need to pay towards your mortgage for the duration of your term, you trade predictability for price.

 

Someone also raised a good point that, as of June 2020, rates are at historical lows. There’s really only one way to go, up. In this kind of environment, it would actually be pretty smart to lock in a low fixed rate. But keep in mind, that the discounted rate will make a big difference when the prime rates are already so low.

 

In summary, if you like the predictability of monthly payments that don’t change during your term, go with fixed rates. You avoid the risk of your rates going up unexpectedly in the next few years, but you lose a bit of pricing power.

Graph 3: Interest paid on Fixed rate vs Variable Rate mortgage

 

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Dig into the raw data used, please refer to sheet here:

Mortgage calculator

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