Fixed vs. Variable-rates

The high cost of a peace-of-mind – Fixed vs. Variable-rates

“Fixed-rate or variable?”  This is a very common and important part of the mortgage discussion.  Understandably, most people want to keep their rate as low as possible in an effort to keep costs low – but if you Google this topic, you typically only find explanations of the two options, i.e. “what they are and how they are different” and links to the “lowest” rates.  These articles typically only scrape the surface of what needs to be a comprehensive comparison and financial planning discussion – encompassing the clients’ complete financial picture and their plans for the future.

When I discuss this topic with my clients, first I explain how variable-rates have been cheaper than fixed-rates historically.  Essentially, the client will be paying more for the peace-of-mind of fixed payments  – insuring themselves against the volatility (both good and bad) that comes with variable rate.

Second, I do the math to see what the difference will be in the monthly payment.  Here’s an example, using TD Canada Trust’s Mortgage Calculator:

Here’s an example using these numbers: Fixed Rate of 2.69%, Variable Rate of 2.05%, Mortgage amount: $300,000, Amortization: 25 years.  The results:

Fixed-Rate Monthly payment is $1,372.45

Variable-Rate Monthly payment is $1,277.60

The difference between 2.69% and 2.05% is $94.85 monthly.  What other product would you gladly pay 7.4% more?

BUT WAIT (as Billy Mays would say), THERE’S MORE!

The higher-rate actually costs you even more than that.  The magic of compounding is great when you are saving, but works against you when you are borrowing.   Even though with the fixed-rate you are paying more per month, at the end of the five-year term you won’t have paid down your mortgage as much as with the lower variable-rate.

After 5-years, you will have a balance of $254,879 remaining on your mortgage.  With variable your balance will be $251,575.  $3,304 less!  This is a difference of $55.07 a month for this term and is a major cost that often is not a part of the conversation.

In this example, choosing the five-year Fixed-rate Term over the Variable-Rate will cost you about $150/month!  That’s a car payment or, if you are like me, 32 Grande Lattes at Starbucks.

The Fixed-Rate will cost you 12% more!

Of course, having a fixed-rate is advantageous in one-area – it helps you budget as protects you from one area of risk – your mortgage payment goes up so high that you can’t make your mortgage payments.  Is there a way to get both the cheaper variable rate and also protect yourself versus the volatility of the variable-rate?

Yes.

I present to my clients the option of taking the variable-rate and setting up a pre-authorized contribution plan into a savings account specifically created to “hedge” against an upturn in the Prime Rate.  In our example, I would suggest a monthly pre-authourized contribution to a savings account of $150.00/month.  You are insuring yourself against upward movement in the variable-rate and automating it.

Also, do not forget that your clients can lock-in their variable-rate mortgage by paying a three-month interest penalty NOT the mysterious and usually-significantly-more-expensive Interest Rate Differential.  This plan avoids that potential future cost.

Three things to take away:

1) There is more to the cost of a mortgage than just the lowest-rate. Lowest-rate does NOT mean lowest-cost.

2) Do the math. Compare apples-to-apples and include ALL the costs including potential future ones.

3) Know your budget and your contingency plans.  Have a financial plan in place now in case the Prime-Rate goes up significantly during the term.

As always, comments are welcome.

Peter

Peter Radonjic is a Mobile Mortgage Specialist for TD Canada Trust.  The opinions and ideas reflected in this article are his only, and should not construe endorsement by TD Canada Trust or any related affiliates.  Please feel free to contact him at 604-789-8104 or [email protected]