Fixed Vs Variable – Consider Penalty Implications

Fixed Vs Variable – Consider Penalty Implications
This would be a simpler topic if we were unemotional beings.  Spock would select variable rate every time.

 

Personally I have found that my life is Variable, therefore so is my mortgage product.

Definitions;

Fixed rate mortgage – just like it sounds; your interest rate is fixed for the length of the term chosen.  This is perceived as ‘safe’.

 

Variable rate mortgage – also much like it sounds; the interest rate is predicated on the Bank of Canada’s Prime lending rate and has the potential to go three directions at any one of the eight BoC meetings per year; either up, down, or remaining constant.  The component of a variable rate mortgage that is guaranteed is the premium or discount from Prime that is established at the outset of the mortgage term.

 

Let’s confirm a few facts about the variable rate product before we go any further;

  • The interest rate cannot ‘spike randomly’.  In fact there are eight pre-scheduled  Bank of Canada meetings at which the decision is made whether to move the Prime lending rate or not.
  • The interest rate will not ‘double overnight’.  In fact the interest rate is unlikely to move by more than .25% following any given meeting.  The Bank of Canada has not moved prime since September of 2010 as of this printing.
  • The payment will not ‘double overnight’.  Certain lenders offer a ‘fixed payment’ option – whereby no matter where Prime moves your payment remains constant for the 60 month term.  (this can be an especially effective product for an investment property, or in the case of the client holding a second property which they’re trying to sell.)

 

Statistically, for the past 40 yrs of history (see 20yrs here) the variable rate mortgage has been the correct choice for reduced interest expense.  At any point when one locked into  a 5yr fixed mortgage rate they effectively entered into a losing proposition.

 

Over the past few years many clients walked into my office adamant that they wanted a 5 yr fixed rate mortgage and nothing else.  I understand this mind-set, after all I did the same thing with my first mortgage.  I made the mistake of listening to my Parents, who had made the mistake of listening the bank, without understanding the banks motives were shareholder profit driven, not looking out for my Mom & Dad’s kid driven.

 

Prepayment Penalties.

Easily overlooked in the heat and excitement of a first time purchase is the question of prepayment penalties.

 

6 out of 10 Canadians will break their current mortgage at an average of 38 months.

 

In the case of a 5yr fixed rate product a prepayment penalty equivalent to ~4.5% of the mortgage balance will be triggered.  ~$4,500.00 per $100,000.00 of mortgage money.

 

It would be incorrect to suggest that any of these mortgages are broken due to the availability of lower rates as lenders structure prepayment penalties to negate any savings from a simple refinance to a new lower rate. Rather, mortgages are broken for a number of other reasons including marriage, divorce, employment or health issues or the desire to leverage capital from the property.

 

A variable rate mortgage, with its guaranteed prepayment penalty of three months interest (only), is a wiser choice for many.  Currently this equates to ~.50% of the mortgage balance, or a prepayment penalty of ~$500.00 per $100,000 of mortgage balance.

 

The short version is that clients currently in five-year fixed rate mortgages with 30-24 months left in their term are being hit with a prepayment penalty five times higher than clients in variable rate mortgages.  This after paying a higher interest rate all the way along as well.

 

Moving forward if interest rates remain constant, as many (including myself) expect them to, these penalty figures will also remain constant.

 

A few reasons mortgages are broken;

  • Marriage (keeping both properties is not always an option)
  • Divorce (in many cases  neither spouse is able to carry the property on their own)
  • The appearance of more children than expected in your household (congrats – triplets)
  • Employment issues, both positive and negative – i.e. transfers, promotions or  layoffs.
  • Health issues
  • A variety of social issues
  • The desire to leverage capital from the property – again for a variety of reasons;
    • To start a business
    • To fund an existing business
    • To pay out high-interest consumer debt
    • To cover the failure of the business – without being forced to sell the home
    • To raise capital to help a family member purchase real estate or otherwise
    • **an important note for workers who have the potential to be transferred to different parts of the province or country, be sure your mortgage is placed with a National lender.  Otherwise you may be forced to pay a stiff penalty to a local lender if you are transferred out of province.  RCMP in particular have to be concerned about lenders that are willing to write mortgages in rural Canada.

 

As you can imagine this list goes on.  All of these things and more are what we call ‘Life’ and at some point some of this touches all of us, both the good and the bad.

 

For many of my clients at least one of these items may have been on the horizon at the time we were discussing their mortgage, and so either a shorter term fixed rate product – or even a variable rate product ( due to its guaranteed lower penalty ) has made better sense than a five-year fixed.

 

At this point I will reiterate a thought that I put out there regularly;

 

Ask your banker or your broker what they have done with their own personal mortgage(s) and why.

In the interests of full disclosure it should be pointed out that brokers and bankers alike are compensated more generously for clients who lock in for longer terms at higher rates.

 

If I were to make an argument in favor of my client locking into the 10 year fixed rather than a two year fixed my paycheck triples.  However I cannot make that argument as I personally do not believe in it at this time.  Instead I prefer to take the time to run the calculations and demonstrate to clients the tremendous advantage of making 10yr sized payments on a variable or even a 2yr fixed term mortgage (1 and 2 yr fixed are like ‘slow motion’ variables).  The extra dollars flow directly to the principal, lowering their mortgage balance faster.

 

Most people’s lives change a fair bit every three years, I know that mine has… since birth.

 

Thank you

Related Posts