Variable, Fixed, Inverted – Michal and Michael Podcast

Michal Sluka – Real estate agent for over 5 years, sold over 300 homes

Michael Huber – Huber Mortgage, 7 years experience

5 Tips for Choosing Fixed vs. Variable

***Besides the fact that the yield curve is inverted and fixed is cheaper than variable***

A mortgage broker’s second most frequently asked question. Should I go with a variable or a fixed rate?

Let’s talk about the historical differences between these two rate options and the people who choose them then delve into why today’s variable vs. fixed rate decision is perhaps easier in today’s inverted yield curve environment.

Mortgage Facts

  • Five-year mortgage terms in Canada are the most common.

  • Fixed rate mortgages are most popular, chosen by 66% of mortgage borrowers.

  • Variable rates are chosen by between 25% and 30%.

Variable Rate Facts

Variable mortgages (or ARM-adjustable rate mortgages) have been less expensive historically. If you’ve had a variable rate mortgage over the past 10-years, you have done well. Variable rates fluctuate with movements in the Bank of Canada’s prime lending rate. This prime rate is affected by Canadian and global economic conditions. When inflation is high, the Bank of Canada will raise the prime rate to counter over-stimulation of the economy. When inflation is low, the prime rate is lowered by the Bank of Canada to stimulate the economy by making borrowing more attractive.

While the variable rate has, over the past 10 years, been lower than the fixed rate, these rates can rise and fall.

  • If rates rise, less of your payment goes to principal.

  • If rates fall, more of your payment goes to principal.

Income, lifestyle and risk tolerance should guide rate decision. Risk-averse, growing families tend to pick the stability of a fixed rate. If you think you may have a hard time weathering a rate rise or, more specifically, you don’t think you could weather a 2% increase to the variable rate, maybe variable is not for you. If you are risk averse and your risk tolerance will not allow you to sleep at night with a variable rate, go with a fixed.

Common Variable Rate Strategy

Utilize your mortgage contract pre-payment privileges and increase your variable rate mortgage payment to what the payment would be at the current 5-year fixed rate.

This is good for two reasons: first, you will pay down potentially thousands in principal.

Second, you will condition yourself to pay a higher amount monthly.  If variable rates do rise during your mortgage term, you will be prepared to pay the higher amount already and avoid dreaded “rate shock”.

Market Timing Strategy

Some people opt for the variable rate then try to switch to a fixed rate before rates rise.  This is tough because even the PhD economists have a hard time predicting when and by how much rates will rise at any given time.

Fixed Rate Facts

Yield on the 5-year Government of Canada bond is the key benchmark for determining the rate for five-year fixed mortgages. Currently, 5-year Government of Canada bonds have dropped and correspondingly, the 5-year fixed mortgage rate has fallen as well.

Why do people choose fixed mortgage rates?

Stability. With fixed rates, you can budget accurately and you always know what your main monthly housing expenses will be. Historically, fixed rate have been more expensive than variables with people choosing to pay the price premium in order to have peace of mind.

Important fixed rate questions

  • How long do you expect to be in the property?

  • How does your prospective lender calculate their pre-payment penalty?

If you may need to break the mortgage before 5 years, opt for a 2-year or 3-year fixed or a variable rate to avoid onerous penalty costs. Penalties are basically the foregone interest to maturity that the lender charges you for cancelling your mortgage before the end of term.

These pre-payment penalties are serious.

65% of Canadians with 5-year mortgages pay mortgage pre-payment penalties.

It’s really important to avoid or mitigate these costs either by picking an accurate term, going with a variable or finding a mortgage lender that calculates their Interest Rate Differential Penalty using the standard calculation.

This technique will save you thousands.

What’s happening today? Inverted Yield Curve

Today, choosing between variable and fixed may not be so difficult because the bond yield curve has inverted; in other words, fixed rates are cheaper than variable rates by about 20 basis points. 20 points cheaper and the stability of monthly costs over 5-years is hard to turn down.

The advice given in this article is meant for a typical rate environment.  Today’s inverted yield curve is not typical.  So…

While rate is important, flexibility is key. Life and events can leave you stuck and, as mentioned before in the discussion about fixed mortgage penalties, you have to plan ahead to avoid major costs that will arise if you need to sell or refinance your property.

Variable vs. Fixed Conclusion

It’s a weird world. Fixed rates haven’t fallen below variable rates for quite a few decades. Why is it happening? Investors are worried about US recession, short term bonds currently have higher yield than longer term bonds. This is not normal. Hence the inverted yield curve discussions. Most of this doom and gloom has to do with imported global economics as the Canadian economy is reportedly strong.

While not typical, this inverted yield curve scenario could be with us for a while because the Bank of Canada has stated that it’s not planning to cut rates in 2020. We’ll see.

Today’s Mortgage Strategies.

New buyer

Here are your choices.  Today, best available variable rate is Prime minus 1% or 2.95%.  Best 5-year fixed is 2.74%.  Seems like a no-brainer to take the safety of the fixed rate.  However, if you are worried about locking in for that length of time, the 2-year fixed and 3-year fixed are both 2.69%.   The shorter time frame will lower any penalty charges you may face if you have to cancel before end of term.

Mortgage Renewals

Same as new buyer scenario.  At renewal you are free to choose whatever you want because your mortgage contract has ended and you are under no obligation.

Mortgage Switches

Fixed to Fixed – calculate penalty to end of current mortgage term, calculate savings from new mortgage going forward.  If it’s a long-term savings, a switch is worth considering.

Variable to Fixed – With variable rates higher than fixed rates, you could pay your 3-month interest penalty and lock into a comparatively very cheap 2, 3 or 5-year fixed rate.  Caveat as always that you need to understand the potential cost of penalty, your 2 to 5-year plans and calculate whether the savings are worth paying the penalty.

Fixed to Variable – No.  Why would you pay a penalty to get into a variable when you could get a lower fixed?

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