Essential Knowledge Series
Most people who have a mortgage or have explored mortgages know about the different rate options available to them. Generally speaking, it can be a tough decision to know what to do in your situation. With my clients, I stay away from the one size fits all approach and analyze each person's current situation.
To see the way we analyze each person's situation, see our previous blog post here.
As for what is right for you, there are three main questions you need to ask yourself before making a decision.
How long do I intend to hold this mortgage?
Is my budget fixed or can I afford any fluctuations in payment costs?
What is the current spread between fixed and variable rates?
1. How long do I intend to hold this mortgage?
The reason you need to ask yourself this question is that the mortgage type will have a significant effect on you financially if you break your mortgage early. For example, let's imagine you just purchased a home in a new city because you relocated for work. If you move often and don't purchase a home everywhere you go, you'll pay a hefty pre-payment penalty to break your mortgage early. Generally speaking, you will pay less on a variable rate versus a fixed when it comes to calculating your pre-payment penalty.
Imagine you have a $500,000 mortgage and a variable rate of 2.50%. If you wanted to pay out the entire amount, your pre-payment penalty would be calculated using a three-month interest penalty. $500,000 x 2.50% / 365 days x 90 days. In this case, you'd pay approximately $4,245 in a pre-payment penalty. A hefty amount, but low relative to the similar fixed amount.
Next, we'll look at the fixed rate calculation. The best online tool for this calculation can be found on Scotiabank's website here. Using the exact same numbers as above and assuming 4 years left on a 5-year term, the pre-payment charge would be approximately $10,102. This is a difference of $5,857 between the fixed versus variable.
You can see why if you are planning to move and not port your mortgage to your new property, the variable would be advantageous in this scenario. If it were the opposite scenario and you knew you'd be staying in the same location for the duration of your mortgage term, the fixed might be the better option.
One important thing to think about - according to the Canadian Association of Accredited Mortgage Professionals, the average Canadian will own 4.5 to 5.5 homes in their lifetime. If we assume Canadians are purchasing their first home at 30 years old and the average life expectancy is 80 years old, the average Canadian would move once every 10 years. That's the average. For you, it might be different. Analyze your situation accordingly and give your best guess of where you'll be in the next 5 years.
2. Is my budget fixed or can I afford any fluctuations in payment costs?
Before you even consider purchasing a home, you have to be sure to complete the most important calculation. Your current cash flow. If your take-home family income is $5,000 per month and expenses are $3,000, adding a $2,500 mortgage payment isn't going to work.
When it comes to a variable versus a fixed rate, you have to compare the rates you can get on the market and where the rates are going in the future. If the fixed and variable rates you can get are both 2.50%, the fixed rate looks good right away. But wait, are interest rates decreasing? If so, maybe that variable rate will decrease to 1.50% in the next few years, at which point the variable rate looks better.
Luckily, if you're mortgage broker has completed their research, they should be able to give you an indication as to what direction the rates will be heading. If the 2.50% payment is the maximum your budget can afford and rates could be going up, the fixed is the way to go. If you have room for some movement and have the opportunity to get a lower rate because of decreasing rates, the variable rate might be worth the risk.
3. What is the current spread between fixed and variable rates?
This final question will overlap with question 2. In question two we analyzed the same rate for a fixed versus a variable. Generally, that won't be the case. Variable rates will be lower than the fixed rates in most cases. Using the current rates as of April 2022 as an example, you'd be looking at a fixed rate in the 4.00% range and a variable rate in the 2.20% range. That's a significant 1.80% difference.
I know what you're thinking, "What happens when the rates go up and my variable rate goes above the fixed rate?". That's a very good question. The answer leads us to look back to history and see what has happened in the past. For a complete analysis of interest rate fluctuations, click here. The last time we saw rates increasing steadily, they only increased 5 consecutive times for a total of 1.25%.
In our scenario of the 2.20% versus the 4.00%, you'd need a 1.80% increase. That's a significant increase. I'm not saying it's not possible, I'm saying it's not probable. Unless the government wants to put Canadians into a very tough financial situation, a 1.80% increase isn't likely.
What should I do?
I would start by weighing your options and answering the above questions. The best option for you would be to reach out to us and let us help you uncover the right decision for you. We have calculators and insight that will give you the confidence to know that you made the most informed decision possible. As of today, variable rates are looking more promising than fixed rates, but in today's world that could change.
As the old saying goes, "There is nothing permanent except change".
Questions/Comments?
Give us a shout in the comment section or find our contact details on the main page of our website at www.triedandtruemortgages.ca
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