July 21st, 2010 
Category: 
Yesterday, the bank of Canada went ahead and raised the prime rate for a second time in a row. The prime rate is now 2.75%. Regardless of what the rate predictions are for next year, the numbers will be reviewed more than once until then. Let’s stick to a safe affirmation here: interest rates will be going up sooner or later. I’m pretty sure many amongst you who locked their rates 2 years ago and missed out on the historical lows are secretly happy since soon enough those variable rate holders won’t make you feel you’re overpaying!
This post will not go over detailed economic analysis or complex mathematical equations on variable and fixed mortgages. This post will present some common sense options to consider if you are part of the following 2 groups:
Real Estate Buyers:
If you’re looking to buy property, borrow strictly the amount you will need and not what the amount the bank is able to lend you. It might be overwhelming to see the amount you can borrow and distracting in the same time where you go on looking for more house than you need. Keep both feet firmly on the ground as such decisions have long term consequences on your finances. Buy only what you need and borrow the strict minimum in consequence. Make sure you have some free cash flow after your monthly expenses in case you end up with higher interest rates after refinancing or in the event you decide to put some lump sum payments in order to reduce the loan duration.
Wondering about variable or fixed mortgage rates? If you believe the economy will be slow to recover, there is a chance variable rate makes more sense than a fixed one over the course of the next 3 years. If not, go with the fixed rate. I will not present a case for either point of views; it will be up to you based on your perception of the economy. Do not believe anyone pretending to know where the economy will be in the next 6 or 12 months, no one knows the future. We can only expect the rates to rise gradually and not in leaps and bounds over the next months.
Going with a variable rate can result in sleepless nights if you will keep on wondering when the next rate increase is coming. If you cannot stomach the risk you can go with a fixed rate and keep your normal sleep hours. On the other hand, if you can handle a little bit of risk, you can divide your mortgage into 50/50 fixed/variable combination which is more bearable since the risk is being balanced out. Take note that the variable rate should still be considered low even when the prime gets closer to 4%.
Real Estate Owners
If you currently own a house and your mortgage is due to be renewed consider the following scenarios:
If you can afford lump sums on your mortgage and the amount remaining is not huge relative to your income, it makes sense to go with a variable rate because you will be able to reduce your debt or potentially close it off within the next 3 to 5 years depending on the amount.
Example: I currently have a 155k variable rate mortgage set for renewal in 2013; I plan to pump a total of 30k into my mortgage each year based on a lump sum payment of 20k plus the principal payments. I intend to keep my rate variable for the next 3 years. If I execute my plan properly I would be ending with less than a 60k mortgage which is no longer a danger on my finances if rates were to shoot up subsequently to 8% for example.
By taking advantage of the low rate period, you would save tons of money in interest and potentially the taxes on this interest since the money you are using to pay your mortgage is after tax money.
Example: You have a 200k mortgage with an amortization period of 25 years and a 5% interest rate. You decide to pay a lump sum of 20k for 3 years in a row. The end result is reducing the amount of time by 10 years and saving 84k in interest payments. You can contribute those 84k to your RRSP and recover their taxes or use this money for anything you wish. Anything you do with this money is better than giving it for free to the banks. You can run your own scenario using the following mortgage calculator.
For those who would argue for investing the lump sum payments instead will agree that the sense of security provided by lowering or closing the mortgage off is priceless. It’s also nice to know that your house is a piggy bank worth tens of thousands of dollars as a plan B.
If you fear for your job security or cannot afford to divert lump sums on your mortgage, it is best to stick with a fixed rate. If you still decide to go with a variable rate keep in mind that higher mortgage payments later on will increasingly limit your free cash flow and your ability to carry other debts.
I strongly encourage you to throw lump sum payments at your mortgage whether you have a variable or a fixed rate. It’s a win win situation.
How are you preparing for higher interest rates?
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[...] I haven’t yet crunched the numbers for this specific scenario, but I don’t quite see rates rising by more than 1% from 2011 to 2014. I could be wrong, of course, but I still see too much weakness in the global economy, overall. Even if we go for the fixed rate and rates somehow skyrocket, we’ll still have to pay the piper his dues once the three years are up. Past analyses have favored the variable rate, and I am still quite partial to taking a variable rate in January. Either way, it looks like mortgage rates are going up, and we’re going to have to accept that. [...]
Great post, Mich. You must have read my mind, because I was just asking the question today, myself. The numbers are so close now that there’s not that much difference between the variable and fixed rate for us, for the next three years at least.
I am still partial to grabbing a variable rate, but the security aspects of being able to sleep at night and not having to convince the wife/girlfriend that everything will be OK is a great benefit of having a fixed rate!
Nice post Mich! Yes, Kevin, keep the wife/girlfriend happy…a happy wife/girlfriend makes a happy Kevin! Are you considering locking into that 3-year fixed rate? Could be a good choice.
To answer your question Mich, my wife and I are already 2.5 years into a 5-year fixed term, so we’re already prepared for higher rates per se. Unfortuntely, I’m paying more than I want to right now (given where rates have been) but our lump-sum payments are helping.
@ Kevin, FC
I will be sticking to variable rate for the next 3 years. I bought my house in mid 2008 and i will be injecting lump sums for the next 3 years. Mortgage should become insignificant by 2013!
I can only reiterate my position regarding lump sums, they save you a tons of money down the road. Very important to make the effort in the first few years to maximize the savings down the line.
Cheers!