The mortgage gamble

The difference between fixed and variable rate mortgages has never been so small, yet the debate rages on over which is the better buy. The Globe and Mail’s Rob Carrick recently wrote an article in defense of variable mortgages, saying that it’s still the cheaper option. Technically he’s right. You can get a five-year fixed rate for around 3% whereas you can find a variable mortgage for about 2.6%. What he fails to mention is that you’re taking on a big risk for a very small reward.

In 2010, when it seemed like another economic collapse was imminent, the spread between variable and fixed rate mortgages was about 170 basis points. Today’s it’s closer to 30. In fact, a friend of mine recently got a five-year fixed rate mortgage for 2.89%, which is a mere 29 basis points above a variable rate. Such deals are easy to find across the country.

Mark Fidgett, a Vancouver-based mortgage broker, believes variable mortgages only make sense when there is at least a one-percentage point spread to fix rate mortgages. The danger, he explains, is when rates rise. If the Bank of Canada increases the prime rate by, say, 25 basis points then variable rate mortgages will also increase by that much.

So if that happens you’ll simply lock in to a fixed rate then, right? Well, by that time, these incredibly low deals on fixed mortgages will be long gone. Robert McLister, editor of the Canadian Mortgage Trends website, explains that fixed rates are based on bond yields, which typically rise in advance of the prime rate. “You get people with variable rates thinking they’ll lock in at the right time, but nine times out of 10 they’re late,” he says. “Bond yields have already moved and so has the fixed rate.”

Of course, you can take the view that rates won’t rise for years, as one expert did in Carrick’s story. Then, technically, variable will save you money. But like investing, timing the marketing can be dangerous. No one knows for sure how the economy will do. If the economy performs better than expected, the BoC could raise rates earlier than expected. While it’s unlikely—some argue the BoC will wait for the U.S. Federal Reserve to increase its rates in 2015—but you never know.

Even if rates don’t rise until 2015 it’s impossible to know what fixed rates will be at that point. Fidgett thinks that we’ll see fixed rates around the 3.25% to 3.5% range for the next year, but it’s not unreasonable to think that rates will get back to 5% in the not to distant future. “It wasn’t long ago that those were great rates,” he says.

One argument variable rate fans make is that over time, they tend to save people money. But it’s hard to make that case when rates have little or no room left to fall. “The odds of variable outperforming are far less then they have ever been in the past,” says McLister.

There is one good reason to get a variable rate today: if you’re planning to sell a house within five years. Breaking a fixed-rate mortgage can be costly since you either have to pay an interest rate differential or a three month interest rate penalty, whichever is higher. It’s likely you’ll end up having to pay that differential, which is far more expensive than the three-month interest rate hit. Variable rate mortgages do not have the interest rate differential fee, only the three-month interest rate penalty. So, if you plan to sell a house within the three or four years of buying it, then consider a variable rate.

Otherwise, it’s hard to make an argument for the variable rate mortgage. You wouldn’t buy a stock strictly for a 4% yield, when a Government bond can pay you the same—it just doesn’t make sense to take on added risk when you can make as much from a more stable investment. It’s the same thing with mortgages. There’s simply not enough reward to put your monthly payments at risk of a rate increase. Plus, who knows if we’ll see fixed-rates this low ever again.