Although rates have increased from their historical lows since the height of the financial crisis, they still remain relatively low. For those thinking about renewing or getting a new mortgage, the age old question of which type of mortgage to go with comes to mind. Is a Fixed Rate Mortgage (FRM) or Variable Rate Mortgage (VRM) better? Lets look at some considerations:
Variable Rate Mortgage (VRM):
A variable rate mortgage is a mortgage where the interest rate changes each month (commonly set to the first day of the month). However, the borrower’s monthly payments remain fixed/constant (usually for the full 5 year term). Changes to the interest rate affects how the payment amount is applied towards the mortgage. The interest rate changes according to the specific retail bank’s mortgage prime rate. If the bank’s mortgage prime interest rate decline, more of the payment goes towards the principal. If interest rate increases, more of the payment goes towards the interest itself. The interest is compounded monthly, unlike in a fixed rate mortgage (semi-annual). VRMs are also referred to as a “floating” rate mortgage.
Fixed Rate Mortgage (FRM):
A fixed rate mortgage is a mortgage where the interest rate is fixed for a specific period of time (the term). The borrower’s monthly payments also remain fixed/constant (usually for the full 5 year term). Unlike in variable rate mortgages, interest is compounded on a semi-annual basis.
Open & Closed Mortgages:
Open mortgages allow you to prepay any amount of your mortgage, at any time without a compensation / administrative charge or fee. Exceptions apply to the Open Variable Interest Rate Mortgages, where it is common that the administration fee applies within the first two years. Open mortgages give the flexibility of increasing your payments to any amount anytime. However, the interest rate is usually a bit higher. Open mortgages are typically available to variable rate mortgages (OVRM) and a few fixed rate mortgage (OFRM) terms (1 yr term, etc), depending on the financial institution.
Closed mortgages allow you to prepay up to a limited amount of your mortgage. Usually, the borrower is limited to being able to pay 15% of the original principal balance of the mortgage per calendar year. Any amount over the limit within a single calendar year, results in compensation charges or fees. The rate is set on the first day of each month. The mortgage cannot be prepaid, renegotiated, or refinanced before maturity, except according to its terms (with compensation fees). Closed mortgages are typically available on both variable rate mortgages (CVRM) and fixed rate mortgages (CFRM), depending on the financial institution.
Which Type Of Mortgage Is Better?
Historically, prior to the financial crisis of 2007-2008, homeowners would have been better off with a VRM in the long run (for 5 year closed). The average interest rate paid with a VRM would have been lower than with a FRM during the last decade. During the financial crisis, mortgage lending rates were at historical lows. Although FRMs were also very low, homeowners were much better off with VRMs (which also included a discount of 1% off the retail bank’s prime rate during those times). In recent years, the mortgage rules had changed to include prime +1% for VRMs, although that has again changed to no longer be the case. VRMs sustained at low rates over the course of a 5 year term, yielded superior results.
The current (1/27/2011) posted rates for a 5 year term at most major retail banks are:
Variable Rate Mortgage :
5 year closed = 3.00%
5 year open = 3.80%
Fixed Rate Mortgage :
5 year closed = 5.19%
A comparison of rates :
Currently, for 5 year closed terms, you can obtain a discounted VRM (-0.15%) of about 2.85%, and a discounted FRM (-1.05) which is about 4.14%. Under the current conditions, the difference between the interest rate for the VRM and FRM has become small, and both look attractive. The variable rate mortgage would appear more attractive due to the initial savings at the beginning of the term. However, it is likely that a borrower will be better off with the fixed rate mortgage, if the difference between the two rates is small. This is due to the inevitable rise of lending rates, in which case low rates over the course of the 5 year term would not be sustained.
2011 Mortgage Rate Outlook
Overnight Lending Rate :
Overnight interest rate hikes of about 0.25 from the Bank of Canada (BoC) would not be unexpected in the second half, or third quarter of 2011. BoC governor, Mark Carney, has also stated multiple times that Canadians should expect and prepare for rate hikes in the coming years. The Bank of Canada and Canadian government will likely take more steps in 2011 to decelerate the housing market. As the economy improves, the increases will become larger and/or more frequent. Any earlier, and the BoC risks stalling the economic recovery. Most variable rate mortgages allow the borrower to switch to a fixed rate mortgage, when they believe rates will start to go up. The idea is that the increases will start small, and there would be plenty of time to allow the borrower to lock into a FRM.
Retail Bank Prime Rate :
However, retail banks will likely raise their prime lending rates before the BoC raises their overnight lending rate. It is also important to note that the two interest rates are actually two different things altogether. In recent years, the major Canadian retail banks have all increased their retail lending rate (bank’s prime rate) regardless of the changes made to the Bank of Canada’s overnight lending rate. This includes Royal Bank of Canada (RBC), TD Canada Trust (TD Bank), Bank of Nova Scotia (Scotia Bank), Bank of Montreal (BMO), and the Canadian Imperial Bank of Commerce (CIBC), etc.
By the time the small increases have taken place, the rate on the fixed rate mortgages would already have likely increased to be much higher than they were at the time the borrower signed for the variable rate mortgage. The average interest rate paid over the 5 year term, would likely have been lower with the FRM at the start.
Bond Yields :
Rates also move with the bond yields, which change and fluctuate continuously. For example, changes in the retail banks’ 5 year posted rate is tightly correlated to the changes in the yield on the 5 year government bond. In general, it can be expected that Canadian bond prices will likely decline from their 2010 highs due to a growing level of household debt, low productivity, and weak exports. This would result in the yield increasing (inversely related).
High Inflationary Environment :
With quantitative easing, fiscal stimulus, and huge government deficits, the laws of economics dictate that a higher inflationary environment will likely follow in the coming years. That is unless the government can act fast enough to negate the effects. However, there is a lot of misconception when people hear the national inflation numbers or headline CPI readings, which does not sound very high. Rising food prices, commodities, taxes & user fees, energy prices, pension contributions, etc, have already been observed. They are signs of the inevitable outcome.
Everyone’s situation is different, and many times there are additional factors that come into play (including your current rate), when deciding on the mortgage (type, term length, open/closed, etc). The above points are issues to take into consideration, in order to better help determine the type mortgage best suited for each situation. Remember also, that the goal is to have the lowest possible cumulative average mortgage rate, over the entire duration that the property requires a mortgage (i.e. until it has been completely paid off).
Given the current conditions and expected outlook, it is likely the homeowner will have a lower average if they go with a 5 year closed fixed rate mortgage (CFRM), rather than a 5 year closed variable rate mortgage (CVRM), at this moment in time.
In general, if we are in or are entering a period where rates are expected to increase during the majority of the term, and the rate difference is small, then it is more likely that a FRM will give a lower average rate. If we are in a period of increasing rates for the majority of the term, and the rate difference is significantly large, it is likely that a VRM will give a lower average rate. If we are in a period of sustained or declining rates for the majority of the term, then it is more likely that a VRM will give a lower average rate, especially if the rate is much lower than that for an FRM.
Thanks and Happy Investing! – © 2011