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Why Today’s Fixed Versus Variable Debate Is All About the Spread

Monday Morning Interest Rate Update for August 24, 2015

by David Larock

toronto mortgage ratesCanadian mortgagors from past generations look on with envy at borrowers today, who must decide whether record-low fixed-mortgage rates and/or rock-bottom variable-mortgage rates are the best option. While past generations would have camped out overnight on the sidewalk to take either of today’s five-year mortgage rates, today’s borrowers still agonize over their choice.

To help inform this age-old decision in our current environment, this week’s post will explain why I think that the spread between today’s fixed and variable rates is the key factor to consider when deciding between these options.

Right now a competitive five-year variable rate with excellent terms and conditions can be found in the 2.00% range, while a good five-year fixed-rate mortgage is in the 2.50% range. The current 0.50% gap between these two options is quite narrow by historical standards, and would be closer to 1.00% under more normal (and stable) economic circumstances.

If you are leaning towards a variable rate today, the 0.50% gap between five-year fixed and variable rates can be thought of as the ‘margin of safety’ that protects you if/when your variable rate starts to rise. Since the Bank of Canada (BoC) typically increases its overnight rate, on which variable-rate mortgages are priced, by 0.25% increments, it would only take two increases by the BoC before today’s five-year variable rates cost the same as the available five-year fixed-rate alternatives.

Of course, this assumes that variable rates won’t fall further, but that assumption seems reasonable with the BoC’s overnight rate currently sitting at 0.50% – and I write this even as the Chinese stock market plummets and contagion fear begins to spread to North American markets.

Besides, even if the BoC did drop its policy rate to 0.25%, which would be considered the lower bound in all but the most extreme circumstances, there is no guarantee that lenders would pass on any additional variable-rate discounts to borrowers. Remember that lenders only dropped their prime rates by 0.15% in response to the BoC’s most recent two 0.25% reductions to its overnight rate earlier this year. Thus, it appears unlikely that today’s variable rates will offer any additional saving in future.

The most common mistake that I see borrowers make when evaluating variable-rate options is overestimating the value of the convertibility feature, which allows all variable-rate borrowers to convert to a fixed-rate term that is equal to or greater than the time remaining on their variable-rate mortgage at any time, at no cost. While this out clause certainly sounds reassuring at first glance, consider the following:

  • Conversion rates are never as attractive as the rates offered to new customers who have yet to walk through a lender’s door, and sometimes they can be much worse. For example, if you have a variable-rate mortgage today and want to convert it to a five-year fixed rate, you should expect to be offered a rate of 2.69% or higher (as compared to five-year fixed rates as low as 2.49% for new customers). Worse still, some of Canada’s larger lenders have fine print clauses that say they will offer you conversion rates that are priced at posted minus 1.00%, which at today’s rates works out to 3.64%!
  • Fixed rates will typically rise before variable rates show any signs of doing so, because they are more sensitive to changes in our inflation and economic growth outlooks. As such, variable-rate borrowers shouldn’t assume that they will be able lock in today’s fixed rates when it looks like their variable rate is about to rise. In reality, their courage will be tested long before then, when fixed rates head higher and they see the cost of their ‘safety parachute’ becoming more expensive.
  • Studies have shown that variable-rate borrowers who convert to a fixed-rate mortgage midterm end up paying more than they would have if they had just locked in a fixed rate at the outset. As such, borrowers shouldn’t use the convertibility option as a determining factor when making their initial fixed-versus-variable call, because history has shown that it is comparatively expensive to actually use it.

Borrowers who are leaning more towards a fixed rate today see the same 0.50% spread between fixed and variable as the cost of the ‘insurance premium’ that they need to pay in order to have borrowing-cost certainty for the next five years.

To put the cost of that 0.50% in context, this premium works out to an extra $74/month on a $300,000 mortgage that is amortized over 25 years ($1,344/month as compared to $1,270/month).

While nobody likes to pay more than they have to, insurance always adds cost in return for protection, and the relatively narrow gap between fixed and variable rates means that today’s five-year rate insurance premium is relatively inexpensive by historical comparison.

In my view, the fixed versus variable-rate question should not be based primarily on a view of where interest rates may be headed over the next five years, which is too long to try to forecast for even the most informed market observers. Instead, borrowers should always start by determining whether they can get a good night’s sleep if they take on variable-rate risk, and then in today’s environment, by deciding whether the saving that is offered by today’s five-year variable rates is worth the risk of higher borrowing costs over the next five years that comes with it.

When the gap between fixed and variable rates is only 0.50%, I think the risk reward trade-off tilts in favour of the fixed rate. Opting for a five-year fixed rate today won’t guarantee you the lowest borrowing cost over the next five years, but it will furnish you with relatively inexpensive interest-rate insurance during a period where economic uncertainly, along with the potential for significant market volatility, is likely to continue for the foreseeable future.

(FYI – Here is a link to a recent interview I did with Rob Carrick for his Carrick Talks Money series at the Globe & Mail.)

Five year Government of Canada bond yields fell by eleven basis points last week, closing at 0.61% on Friday. Five-year fixed-rate mortgages are still offered in the 2.49% to 2.59% range and five-year fixed-rate pre-approvals are available at rates as low as 2.69%.

Five-year variable-rate mortgages are available in the prime minus 0.65% to prime minus 0.80% range, depending on the size of your mortgage and the terms and conditions that are important to you.

The Bottom Line: I think that today’s 0.50% gap between five-year fixed and variable rates makes the fixed option more compelling in the current environment. While this means that you are locking in a higher cost at the outset, this ‘rate-insurance’ premium is cheap by historical standards. In my view, trading a small potential saving today for future cost certainty seems like a reasonable price to pay for a good night’s sleep.

David Larock is an independent full-time mortgage broker and industry insider who helps Canadians from coast to coast. If you are purchasing, refinancing or renewing your mortgage, contact Dave or apply for a Mortgage Check-up to obtain the best available rates and terms.
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