Fixed rate vs. variable rate mortgages
May 14, 2010 12:48 PM   Subscribe

After years of renting I'm planning on purchasing a condo. I've gone to a couple of banks to get approval, but I don’t know if I should stick with the ‘traditional’ 5-year fixed-rate mortgage or go with a shorter term. Which one will cost the least? Is the threat of spiking interest rates considerable or overstated? (This is in Canada)

I’m looking to borrow around $180,000. My down payment will be less than 10% of that, which in Canada means I’ll have to get loan insurance. The thing is, the differences in interest rates between fixed-rate and variable-rate mortgages seem huge: ING Direct's rates are 4.59% for a 5-year, but only 3.15% for 1-year -- and 1.75% for what they call a "5-Year Variable". (I have no idea what the "5-year" part refers to. Aren't variable-rate mortgages readjusted every few months?)

How high would interest rates need to jump for the 5-year term to be the better deal? Are the banks pushing this option because they have my interests in mind, or their own? (I think I know the answer to this one, which is why I'm here.)
posted by The Lurkers Support Me in Email to Work & Money (21 answers total) 3 users marked this as a favorite
Using this mortgage calculator, and the 4.59% rate on a $180,000 loan for five years, I come up with a monthly payment of $3,363. Is this really what you're intending?
posted by netbros at 1:14 PM on May 14, 2010

The term ("5-Year") is the length of time that the contract lasts.

Note that the rules recently changed, and you have to be able to qualify for a 5 year fixed rate, even if you're applying for a variable rate mortgage at a lower rate and/or shorter term.

The variable mortgage you mention is quoting the current interest rate. By and large, the variables are cheaper, but the fixed rates are nice if you're trying to budget (you always know what you'll be paying every time). Most people like certainty, and so they go for the fixed-rate mortgages.

As for cost, the less you're paying in interest (so the lower the rate), the "cheaper" the mortgage.
posted by lowlife at 1:14 PM on May 14, 2010

Oh, and "term" is different from "amortization." Most people sign up for a five year mortgage with a 20, 25 or 30 year amortization. In other words, you're signing a contract that says "I'll agree to pay you for five years on the basis that if I did this for (say) 25 years, I'd be paying off the loan."
posted by lowlife at 1:16 PM on May 14, 2010

I've had really good repeated luck finding great variable rate with good options to fix in with PC financial. Believe it or not, their customer service to figure and explain all this stuff out to me has been excellent. I've gone 2 rounds of variable mortgage with them. They're backed by CIBC. Over the past 10 yrs we've saved thousands compared to my friends who've done fixed. Even last year, the fix in rate which can be opted in at any time was lower than the fixed rate.
posted by kch at 1:25 PM on May 14, 2010

The banks are going to set their fixed rate to something that they're unlikely to lose money on, so variable rates usually work out better for the borrower (looking back at historical rates backs that up). But you lose predictability -- the rate could jump significantly and result in higher payments down the road, so if you don't have a lot of cushion you might be better off with a fixed rate. Right now the difference is probably large because everyone figures interest rates will be going up significantly in the next five years due to the improving economic situation.
posted by Emanuel at 1:27 PM on May 14, 2010 [1 favorite]

No one really knows what interest rates will be in the future. Right now, rates are very, very low compared to rates in the past. Will they rise? Probably. How high and how fast? That's pretty hard to guess. The banks charge higher interest for longer term fixed-rate mortgages because they think that interest rates will rise in the long term and because they are assuming the risk that interest rate will rise a lot in the long term. Mortgage rates are fairly competitive, so you don't need to worry that one option is inherently much better for the bank and worse for you.

It can be a little complicated to figure out how much interest rates need to rise to make the 3 or 5 year fixed-rate mortgage a better deal, but very roughly the average interest rate over the term would need to be about the same as the fixed rate (actually, if the variable rate starts out low and rises slowly to become higher at the end, with the same average rate as the fixed term, you'd do a little better on the variable rate, because you'll be borrowing more money at the lower rate early in the term and less money at the higher rate at the end of the term. You can play around with a mortgage amortization calculator (there are many available online and one on the ING site) to see how changing interest rates will change your monthly payments.

The big issue here is risk. If you think you could afford to pay a much higher monthly payment on your mortgage (what if the variable rate is 9% in 3 years?), then you can consider the variable-rate mortgage. If you can't take that risk, then you'd better stick with the fixed rate mortgage. The fixed-rate mortgage is a sure thing (for 5 years), while the variable-rate mortgage is riskier. Of course, if you are choosing a 5-year term fixed-rate mortgage, you are still assuming the risk that your interest rate will be much higher when you get a new mortgage in 5 years (though you can also change the amortization period at that time).

If I were making this gamble myself, I would choose the variable rate mortgage.

(I have no idea what the "5-year" part refers to. Aren't variable-rate mortgages readjusted every few months?)

This means the term of the mortgage is five years, i.e. you will sign an agreement to continue paying ING for a total of five years, at which point you'll have to get another mortgage.
posted by ssg at 1:30 PM on May 14, 2010

I recently renewed with ING. I've been a fixed-rate for the past two terms (three, then five), and took a bath (relatively speaking, of course - even fixed rates have been historically low for the past few years). Variable interest rates generally end up costing less. I decided to finally go with a variable rate, since my back-of-the-envelop calculations said that the interest rate would have to jump one percent per year over five years for the fixed rate to be cheaper. I don't see interest rates jumping that fast.

But keep in mind that the era of super-low interest rates is likely coming to an end. I've seen predictions that prime will climb by a full percentage point by the end of the year after the Bank of Canada unfreezes it (likely on June 1). I'm betting it will level out a bit after that, but I could be quite wrong about that. I've got enough leeway in my monthly budget that I can handle the uncertainty.
posted by flipper at 1:36 PM on May 14, 2010

lowlife writes "Oh, and 'term' is different from 'amortization.' Most people sign up for a five year mortgage with a 20, 25 or 30 year amortization. In other words, you're signing a contract that says 'I'll agree to pay you for five years on the basis that if I did this for (say) 25 years, I'd be paying off the loan.'"

Also note that some people have terms and periods that are the same. Either because they only have five years left on their mortgage or they went longer on the term. It's possible to get a 25 year mortgage with a 25 year term.

And while I don't know if this always the case when I was last considering a variable rate (I generally choose fixed because I like the stability) all the mortgages I considered had rate caps a few points above current prime. So if the variable rate was 2.5, the fixed 4.5, the variable might be capped at 8. So if you sign a 5 year term and in 2011 rates spike to 20% you'd be paying at max the capped rate.
posted by Mitheral at 1:53 PM on May 14, 2010

If this works the way it does in the UK, the mortgage term is NOT five years, but 20, 25 or something similar. The five years refers to the length of time that the interest rate is fixed.

It's a gamble - I fixed my rate in 2006 when rates here were high and rising, and now they've fallen. But what I do have is the absolute certainty of knowing exactly how much my repayment will be each month until the fixed-rate period expires.

At that point I can either fix the rate again for the next five years or whatever period I choose, or go onto the standard variable rate and wait to see how interest rates move and if they start to rise again, I can then enter a new fixed rate for another few years.

Usually there's a fee to transfer to a new product, so you have to factor that into the cost of the lower fixed rate over a shorter term. For me, the fixed rate was best for my peace of mind, because with just one income, I couldn't take the risk of a huge rise in rates, even though, because rates have fallen, my repayments have ultimately been higher than if I'd been on a variable rate of interest.
posted by essexjan at 1:56 PM on May 14, 2010

I have to admit I'm mystified about the suggestion that a five-year term is "traditional". To my way of thinking, a term of 20 to 30 years is traditional.
posted by yclipse at 2:01 PM on May 14, 2010

I am only talking for the US. If I had some money I would buy a condo but with along term fixed mortgage rate and little money down. If inflation takes off then inflation pays for your condo. If it doesn't you can always foreclose.

Who knows what the future brings?

"If you have money you can speculate,
if you have little money you can not speculate,
if you have no money you must speculate...."
posted by yoyo_nyc at 2:03 PM on May 14, 2010

yclipse: in Canada five-year terms are the norm. It's rare to have a term the same length as the amortization period (unless the amortization period is < 5 years). From what I've heard, that differs from the US where it's quite common to have a 25-year fixed rate.
posted by Emanuel at 2:09 PM on May 14, 2010

I don't want to be the market-timing douche in this conversation, but there are some who believe that the Canadian market is severely overheated due to cheap credit. It might be worth it to wait a while to see what happens. Check out:

That being said, if you have the money, can afford the payments even if rates go up by quite a bit, and plan to stay in the condo for at least 10 years, you'll probably be fine.

Historically, sticking with the variable rate is more advantageous, but you never know what your payment is going to be over the next while. If you can stomach the risk, go with the variable rate. Me, I'm a wimp so I will go fixed when the time comes to buy.
posted by sid at 2:31 PM on May 14, 2010

Some of this decision is about buying style as well.

The traditional approach to buying a home has been "buy as much home as you can afford" and when you do that you really, really want to fix the rate because you're already as financially stretched as you can be making payments (until that mythical day when you "grow into" your mortgage payment and it no longer strings like a mother fucker every month.)

Alternatively, you can buy a house you can really comfortably make payments on and take the variable, betting it will work out to your advantage over the life of your mortgage. We calculated that the interest rate could rise to a Thatcher-era 13% before we'd be paying what we were paying in rent, so that was an easy choice for us.

Your ability to make that choice is hugely influenced by your income and your down payment, but if you do indeed end up buying "as much house as you can afford" then yeah, opt for the fixed so you know you can keep affording it.
posted by DarlingBri at 5:02 PM on May 14, 2010

I'm also buying a condo and wondering the same thing so I'm watching this closely for brilliant advice. If I may make an only slightly unrelated suggestioned: Have you considered getting a mortgage broker? There are dozens of mortgage-granting institutions out there and they each have lots of options beyond just whether the interest rate is fixed or variable. A mortgage broker can help you sort through your options and explain the ore subtle differences between them.

You don't pay the broker anything and there's no contract that obligates you to take a mortgage through them if you decide you don't want to.
posted by If only I had a penguin... at 5:37 PM on May 14, 2010

What's Canada's current economic policy? Here, they will continue to rise until home loan rates reach about 8-9% - that's stated Reserve Bank policy. Canada will also have some kind of policy about the "ideal" interest rate.

Whether you're better off with a fixed rate long-term mortgage (ironically, when I was a young adult 25-30 year fixed rate mortgages were the norm) or a short-term variable rate depends partly on the stability of your income but also your intentions for the property. People looking to live in the property long-term would finance differently than those planning to sell within a few years.

I don't know about Canada, but I know that my own nation and several others are expecting further waves of mortgage collapse as the economy heats up again. One option you might want to consider - and which used to be fairly common here - is combining fixed and variable rates. This can work out especially well when interest rates are quite low and vulnerable to price drops - which you will be with only a 10% down payment.

Another thing to look at is what % of your income would be going to service your mortgage and whether increased repayments would tip you over the financial edge. Interest rates are likely to increase faster than wages for the immediate future, so you'll be extremely vulnerable if you don't have the recommended 8-12 months buffer fund of money which would allow you to continue paying the mortgage if your income drops and your payments increase at the same time.
posted by Lolie at 5:41 PM on May 14, 2010

On the topic of making sure you can afford it if the variable rate goes up, remember that this is worked into your approval. So when I got my pre-approval the variable rate was at 1.8 but the law required that I only be approved for as much mortgage as I could still pay at a 6.1% rate. Assuming you trust your bank's assessment of what you can afford (and you may not), then you should be able to afford the variable rate even if it goes up. And if you put away the difference between the payments at the current rate and what the payments would be at the higher rate for which you were approved, then if and when it goes up past that rate you should still be able to use your saved buffer money to make the payments.

Huh, I think I just talked myself into taking a variable rate for myself.
posted by If only I had a penguin... at 5:59 PM on May 14, 2010

Meant to include an example in my post above. The average mortgage here is for $300,000 and the Reserve Bank has increased interest rates by one quarter of a percent 6 times in the last 12 months.

People who took out a mortgage 12 months ago are now paying about $300 per month more than they were a year ago (thus the mortgage collapse with people who could barely afford the repayments when interest rates were at rock bottom) and rates will continue to rise (although more slowly) for the immediate future. You really need to look at your capacity to accommodate those kinds of rises and how difficult it would be for you to find that extra money.
posted by Lolie at 6:02 PM on May 14, 2010

Fixed Rate
Pros: You know what you'll be paying for the next 5 years, so it's good for stability.
Cons: If rates go back down, you'll feel dumb.

Variable Rate
Pros: On average, people who take variable rate mortgages pay less. I don't have a reference, but that's what my research indicated when I was looking for my mortgage.
Cons: You're at the mercy of the market and the Bank of Canada.

I took a 5-year fixed rate about three years ago, and boy do I regret it. Rates went down several percentage points since then, so I feel like I'm getting fucked. But at that time, rates were still going up. If they had continued to go up instead of down, I would be saying today that I'm glad I took a fixed-rate mortgage.

The fact is that the banks hire people to determine rates who know more about this than most of us do, so there's no way to "out-guess" them. But sometimes you might get lucky.
posted by Simon Barclay at 6:16 PM on May 14, 2010

If you go with a variable rate, most institutions will let you switch it to fixed at any time*. So if interest rates start to go up, you can at least get a handle on it. Of course, the locked in rate by that time will be higher than if you decided to go that route from the beginning. So yeah, it's a gamble and probably depends on your risk tolerance.
* from ING "Our variable rate term allows you to take advantage of low interest rate periods. When ING Prime Rate is low, you'll pay less. There is no guarantee that Prime will not change. But don't worry – you can lock into a 3 year fixed rate term or more anytime at no charge."
posted by nelvana at 6:30 PM on May 14, 2010

I'm pretty sure variable is basically always the way to go. Even if things start climbing now, think about how much rates woild need to move to hit what you pay with a 5 year fixed rate. I think rates will move up, but definitely not that much.
posted by chunking express at 7:10 PM on May 15, 2010

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