Variable Rate Mortgages: Not That Good of a Deal?
We all know that variable rate mortgages result in lower interest costs than fixed rate mortgages the vast majority of the time, leading us to question the sanity of anyone who chooses a fixed rate even when exceptionally low rates are available. Or do we? An insightful post from Canadian Mortgage Trends shows why the common statistics are wrong.
According to well-known studies from Moshe Milevski, variable rates come out on top 88-90% of the time. However there are several reasons that we don’t have the same options now that led to those results:
- His studies were based on posted rates, which today are a mockery of Canadians’ financial ignorance. If you use discounted fixed rates similar to those you can get today, variable rate mortgages win only 75% of the time.
- His studies also used a larger variable rate discount than you can get today. Using a discount similar to those you can currently get on a variable rate, they would have come out on top approximately 50% of the time.
- The data he studied was from 1950-2000 in one instance and 1950-2008 in another. Another common study was from 1975-2011. These all include the great bond bull market from around 1980 to 2010, when anyone who bet on falling interest rates came out ahead. Interest rates cannot come down 15% in the next 30 years. The effects of this have not been tested.
Unless posted fixed rates really were the best you could get in the past it seems that the options today don’t point to variable rates doing better on average. I see fixed rate mortgages as a reverse bond and I believe the bond market is slightly irrational today.
There is a reasonable chance that interest rates will stay low for the next few years and give an advantage to variable mortgage holders. But if interest rates stay completely flat, choosing a super-cheap variable rate of 2.55% over a fixed rate of 2.99% would only save you a total of approximately 2.2% in interest over 5 years. If you made that same choice and interest rates went up 0.5% at the end of each year over the term of your mortgage it would cost you an extra 5.6% (approximately) in total interest. 10-year fixed mortgages may be an even better deal since they provide a much longer lock-in at a slightly higher cost and would be a big win if we have an inflationary decade.
There’s no guarantee rates will go up by 2% in the next 5 years. They could rise less than that or even more. If the choice between fixed and variable typically has even odds, and there is a lot more room for rates to rise than there is for them to fall, today’s conclusions may be different than the usual decision. If rates do fall enough I’ll just refinance again to get some extra savings.
Are fixed rates an expensive insurance or just another option that ends up with the same result on average? I’ll let you know in 5 years!