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Hard choice: Variable & Fixed?

The economy is recovering, the interest rate is rising. So should we all opt for fixed rates?Not necessary.

Right now the variable rate is at around P-0.65% (currently at 1.85%), which 5 year fixed rate is at 4%. So the gap is 2.15%. For a $200,000 mortgage with 35 years amortization, the monthly payment difference is about $235. This is a significant amount.

Whether you take advantage of today's lower variable rate depends on how fast the Bank of Canada will raise the prime rate. Each year Bank of Canada will have 8 meetings to decide the overnight rate. Let's assume that it raises the Prime rate 4 times each year for next 2 years. (That assumes economic recovery is quite smooth and inflation pressure is quite high.) Normally it only raises the rate by 0.25% every time. That means after 2 years, the varible rate will be 2% higher, 3.85%, close to 4% fixed rate.

Since the variable gradually increases from 1.85% to 3.85%, the average rate over the 2 years is 2.85%. That means over 2 years, it saves 1.15%*2=2.30% by taking variable. If in the next 3 years, if the average variable rate is 2.3%/3=0.75% higher than 4%, the variable rate holder will be worse off. That translates to the rate increase from 3.85% to 6.3% gradually over last 3 years, which equals to 10 times rate hike, 3-4 times a year.

In Sum, the above senario is: Bank of Canada raises overnight rate 4 times/year in first 2 years, and 3 or 4 times/year in last 3 years. In that case, variable rate holders will break even. Only when Bank of Canada raises rate more frequently, variable rate holders will be worse off.

So what is the chance for the above or worse senario to happen? My personal opinion is it is very small. Economy recovery won't be a straight path. It would be up and down long process, which means rate hikes can't be too frequent or too fast. Otherwise, smooth recovery might be at risk.

So chances are varible rates will still save mortgage holders money over next 5 years. But keep in mind that if you are absolutely conservative and want to be worry free, you might take 5 year fixed rate straight and sleep well over next 5 years.

I will suggest you look at your financial picture to decide when you decide on variable or fixed. Please feel free to contact for a free detailed consultation. Don't forget: I not only help you with mortgage financing but also help you plan your personal finance to maximize your wealth.
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