Then using prepayments, boost the variable payment by $72 per month to $1,342 – the same payment as you would have been making on the fixed rate.
Variable vs fixed rate mortgage: Pre Payment Result
By increasing the payment on the variable rate to be on par with the fixed rate, we are taking advantage of the variable vs fixed rate mortgage to pay down the mortgage faster.
This helps to reduce risk because as we spend time getting ahead on payments near the beginning of the mortgage, it buys us time later on in the term when rates are more likely to increase.
Even if variable rates surpass, or go higher than the fixed rate comparison, it would still take some time – perhaps years – for you, the borrower, to actually end up paying more for the variable rate mortgage vs fixed rate mortgage option.
This concept will be expanded on below, with more specific reference to timing.
Variable rate mortgage vs fixed rate mortgage: Not if but when rates increase
When variable rates eventually start increasing again, and your payment increases as a result of the variable rate increase, you could simply remove the additional pre payment that you were making at the beginning of your mortgage to help keep your payment more consistent over time.
So even though you would not be hammering away and getting ahead as quickly as you were, you would have already made substantial progress on your mortgage, and you could have the peace of mind of a built-in mechanism to keep your mortgage payment more consistent.
We will take a more in depth look just below, on how this might look over the next 5 years.
Altrua Financial can work with you to easily implement this kind of risk mitigation strategy with the lowest rate variable mortgage.
Variable mortgage vs fixed: How variable offers more flexibility and lower penalties than fixed
Closely related to lowering risk as seen in the last point, the lower penalties and increased flexibility built into a variable rate mortgage are a cornerstone of a variable rate.
When looking at a variable vs fixed mortgage, it should be taken into account that, especially during the first 3 years of a fixed rate mortgage, the penalty to break the mortgage can be extremely high.
As a mortgage broker for over 15 years, I have seen many individuals faced with massive ‘interest rate differential penalties’, when breaking their mortgage for any number of reasons:
- Refinancing to pull out equity
- Switching into a lower rate
- Family changes
- Many more…
This trend was especially the case in 2021 as many who are in a fixed-rate mortgage in the mid to high 2% range were faced with cost-prohibitive penalties in the $10,000’s to break their higher-rate mortgage. This was not the case for those in a variable rate mortgage, and this kind of flexibility could certainly come into play in 2022-2023 as rates may threaten to increase.
While a detailed discussion of penalty details is beyond the scope of this article, the point is that most variable rate mortgages (the ones without terrible fine print) will only ever charge 3 months interest penalty if you end up breaking the mortgage. The 3 month interest penalty is far lower – often to the tune of thousands of dollars lower than comparable fixed rate mortgage penalties.
Five years, the typical mortgage term, is a long time, and it can be difficult to tell exactly the way things will play out further down the road. So an important financial planning strategy is to remain flexible and agile to help accommodate changes.
The variable rate mortgage is, in many cases, the right financial tool to help accommodate these changes.
I also contend that the lower penalty of a variable rate, offsets much of the risk associated with a fixed vs variable mortgage.
Timing a Fixed Rate Lock-In?
The points mentioned so far mainly apply to the period where you are in a variable rate.
One of the fundamental benefits of a variable rate is the ability to lock into a fixed rate.
First, it is helpful to understand the difference between fixed and variable rate pricing. The key to understanding fixed rates, is that they are bond market driven (bonds being Canadian national debt, in the form of a tradable debt instrument, and traded on international markets). In other words, the central bank does not increase or decrease fixed rates, the bond traders, and their perception of where central bank/variable rates will end up in 6 months – 1 year down the road, will in a highly correlated way, price the fixed rate sooner than later. In other words, the pricing of the fixed rate is an anticipation of where the variable rate will go in the short – medium term.
There may be some volatility in fixed rates, in early 2022 – leading towards a fixed rate decrease in 2022 (because of Omicron variant, supply chain recovery, reduction of inflationary forecast, and fundamental economic woes).
So timing the lock in to a fixed may be more difficult to anticipate in 2022, and the main advice currently, if you decide on a variable rate is to plan on holing the rate even as variable rates increase throughout 2022 and 2023, and NOT locking into a fixed any time soon. With such significant discounts in variable rates currently, as of January 2022, there is a lot of runway for variable to catch up to fixed.
Accordingly, there is substantial savings and ‘risk mitigation’ (as discussed above) that may be had until the point where your variable rate, catches up to the fixed rate, and even then – you have not yet lost. Indeed, if you save with your variable rate for the first half of your term, then rates will need to go up enough in the second half of the term, to ‘pay back’ those savings to truly break even. This would require perhaps a 2.5% – 3% increase in the variable rate in the next 5 years (with the higher rates weighted towrds the second half of a 5 year term), which, for the reasons discussed previously, is not likely.
Variable Vs Fixed Savings: A realistic example/ scenario
If you start of with a 1.25% variable rate today. You could have been approved for a 2.54% 5 year fixed rate.
In 2022, the variable rate increases by 0.75%. So you are now at 2%. The government/ central bank decides to wait 6 months to see what the after effects are, of the rate increase.
Nothing too bad surfaces economically in 2022, so in early 2023 the rate is increased another 0.25% and then in mid 2023 the rate increases by another 0.25% for a total 0.50% in 2023, bringing your variable rate in early 2024 to 2.50% or right about what you would have paid for a fixed rate. Hypothetically, the government leaves rates for another 6 months without increase, to see the effects of the increase, brining you to 2.5 years into a 5 year term, or half way through the term.
Now the question is – how much have you saved for that first half of the term? You will likely be thousands of dollars ahead, in interest savings.
Now rates have to continue increasing, another 1% – 2% in the second half of the term, for you to ‘pay back’, or break even with a fixed rate borrowing cost, let alone lose versus a fixed rate.
Given an example scenario, such as described above, rates would have to increase very significantly and very quickly, for you to lose versus a fixed rate.
At Altrua Financial, mortgage brokers, we routinely conduct specific cost benefit analysis for clients to help ensure their best rate decision, savings and peace of mind for their mortgage term.
The conclusion here, is NOT to lock in a fixed fate during the term, and instead to ride out the rate increases, as more than likely the increases will not be too much, too soon.
Variable- Fixed Rate Lock in exceptions
The information in this article is an opinion, based on in depth research and significant experience. However if inflation or some other economic anomaly becomes out of control, it could absolutely make sense to flick the safety switch, pull the parachute, and lock in to a fixed rate.
OR if there is another recession within 5 years, and central bank rates are lowered, there could be an opportunity to lock in to a fixed rate, in the low- high 1% range. From this perspective, a variable rate can indeed be see like an insurance policy against a recession during the term.
Why a fixed rate mortgage will still be the best path for many.
There’s nothing that will ruin one’s credibility like being 100% one sided for one idea or another, and this can’t be more true when looking at the variable vs fixed mortgage discussion.
I believe that the variable strategy described above is best for many, but not all mortgage holders.
There is one golden aspect of a fixed mortgage rate that is hard to put a price on: peace of mind.
How does one measure peace of mind? It’s nearly impossible to measure and the value of it can be near infinite.
Fixed rate mortgages are designed to provide peace of mind, and with rates at such low levels as they are at in 2021, how could you really go wrong by keeping things simple.
‘Set it and Forget it’
I have attempted to show why and how a borrower is likely to save money with a variable rate-fixed rate timed strategy, however what’s the point in saving money if you’re constantly stressed out about it.
There are no guarantees out there, only past experience and likelihoods.
So, for those of you that have made it here to the end, perhaps the real conclusion of the fixed or variable mortgage conversation should instead be: Fixed and variable are both the best decision – depending on who you are.