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John Bordignon
Chief Economist for MERIX Financial
A fixed rate mortgage has the same payment for the entire term of the loan. An adjustable rate mortgage (ARM) has a rate that can change, causing your monthly payment to increase or decrease.
Which one is better? This is a question that is often asked and sometimes hard to answer as it depends on clients ability to deal with fluctuating rates as well as their individual tolerance for risk in a volatile interest rate environment
Although no one can predict rates, we do have to look at historical cycles as an indicator to the future, again, history is not a guarantee or a “sure fire predictor” of the future, however, it does provide insight. We are presently at the lowest short term borrowing rates in history.
FACT: The average prime rate from January 1 2000 to December 31 st 2009 was 4.94%, with a high of 7.50% and a low of 2.25%, during the same period.
Our low interest rate environment has been influenced by government intervention because of global slowing economic conditions, and a low interest rate environment is meant to lower borrowing costs in order to stimulate spending. Canada has faired better than most countries however is still impacted by global economic factors.
Once the global economy begins to show some recovery, the government will commence increasing short term rates, thus an increase in prime.
QUESTION: The real question is not if interest rates will rise however when will they rise and how quickly?
ANSWER: No one knows…, however it is a safe assumption that they will…, if you make the following assumption that prime rate will increase by .25% every 4 months commencing December 2010, what would be the impact and would my client be better off in a 3 year ARM or 3 year fixed rate product.
The chart below illustrates the impact:
We are assuming the client can obtain a 3 year ARM rate of Prime – .70% or 2.05% and can obtain a 3 year fixed rate at 2.90%. Based on a .25% increase in prime every 4 months, prime will have reached 5.00% by the end of the third year, basically back to its 10 year average.
Based on the above assumption and the following scenario:
- Mortgage Amount = $250,000
- Amortization (months) = 300
- 3 YR Fixed = 2.90%
- 3 YR ARM = 2.05%
- PRIME = 2.75%
- 3 Year Fixed Payments * = $1,172.57
- 3 Year ARM Payments * = $1,065.73
* simple interest
Over the 3 year period the client in the 3 year fixed rate product will have saved more than $1,809.27 compared to taking the 3 year ARM at P rime – .70%. The savings are comprised of:
- $494.72 in principal balance reduction
- $1,314.55 in interest savings.
In addition, by the third year the client in the ARM product would have seen his payment increase to a high point of $1,344.31.
Definitely food for thought.
About Merix Financial
Merix Financial, partnering exclusively with highly experienced and qualified Mortgage originators, provides extensive, innovative and competitive mortgage and home equity line of credit options for Canadians.
Merix Financial’s primary focus is on providing not only competitive interest and payment options for originators to offer their clients, but unparalleled service experience that originators and consumers demand and deserve.
The mortgage process is an extremely complicated and enormous financial commitment for consumers, and Merix supports the consumer’s essential need for qualified, expert financial advice by aligning itself exclusively with only those highly qualified originators who have demonstrated superior experience in the mortgage industry.
An Updated Variable / Fixed Rate Comparison
Courtesy of Bernice Lim, from Street Capital, we bring you an updated variable / fixed comparison.
The comparison takes as a base the prediction of many economists, who see rate hikes of as much as 300 BPS Within the next 2 years. Keeping this in mind, the comparison has been updated to reflect a 300 BPS increase over the next 24 months.
- It compares a mortgage at P-50 (currently 1.75%) to a 5 yr fixed at 4.49%
- It factors in increases in prime over the next 24 months. Prime would go up to 5.25%
- It places the monthly payments for both products to be the same (take the variable product, but make payments at the fixed rate).
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The variable product has net savings of over $4,700 over the 5 year term – even with a 300 BPS increase in prime!!!
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Results of Comparison
Mortgage amount of: $250,000.00
- Option 1 / Option 2 Principal Balance after 5 Years $214,688.59 $219,454.81
- Option 1 Interest savings (-$costs) at end of 5th year: $4,766.22
- Option 1 results in paying more (-$less) in mortgage payments after 5 years by -$0.00
- Option 1 principal balance after 5 years will be -$4,766.22 less than the Option 2 Mortgage
- The Option 1 mortgage has an advantage (-$disadvantage) of $4,766.22 over Option 2 after 5 years
* This sheet is for information purposes only and accuracy is not guaranteed.
Mortgage FAQs Updated for 2010
Today, the average Canadian is much more savvier and informed about mortgage options than 3 years ago, which makes the task of explaining to a potential customer the different mortgage options a lot easier for a mortgage broker.
We have assembled below some of the most popular questions related to fixed & variable rates, terms and mortgage types, with the aim of providing as much quality information as possible to help you make the most educated decision within your realm.
What is Fixed Rate? – The rate charged on the mortgage remains steady for the entire term of your mortgage, for example: 3.79% for a 5 year term
What is Variable Rate? – The rate charged on the mortgage floats based on the Banks prime rate, for example: Bank prime less .40% = (Bank prime as of March 15, 2010 is 2.25% so prime (2.25%) less .40% = 1.85%)
What are the advantages of 1 year fixed? – based on the current discounts with variable rates this is not as attractive an option as it has been in the past.
What are the advantages of 2 year fixed? – not a great option when you look at the discounts on variable rate mortgages
What are the advantages of 3 year fixed? – If you compare to a 5 year fixed then there is a great interest savings during the term of the mortgage. Drawback is with rates rising why taking a chance over year 4 and 5!
What are the advantages of 4 year fixed? – rate difference between 4 and 5 years is not significant enough to take a 4 over a 5 year with rates rising. Major plus is that most people refinance their mortgage after 3.5 years so this option might lessen or eliminate the penalty!
What are the advantages of 5 year fixed? – most people pick the 5 year option for their mortgages. This may be one of the best options based on the rising interest rate environment. With most experts picking rates to begin their rise in late 2010 then this may be one of the best stress options!
What are the advantages of 7 year fixed? – significant rise in rates over the best 5 year rates. In some case up to 1 ¼ % higher. This is not a great seller for the lenders and if considering and not planning on moving or refinancing then choose a 10 year term
What are the advantages of 10 year term? – Think about having the same rate and payment for 10 years! Good idea? Let’s explore… 1 ½% jump in interest over a 5 year! After 5 years you can refinance without the awful IRD (Interest Rate Differential) only 3 months interest penalty! Does paying the extra interest make financial sense? If you set your 5 year mortgage payment at the 10 year payment think of all the extra money you would payoff from your mortgage!
How about Variable Terms? – If your plan is to ride out the variable for the short term then lock into a fixed term than my suggestion is to lock in NOW! The reason is this, with rates at historic lows and the variable at historic lows then we have hit the lowest for both rates. If you ride the wave for a year then plan to lock into a 5 year rate think about this. What if the 5 year rate has risen to near 5 %? Would it not make more sense to take the 5 year fixed rate now OR continue to ride the wave of the variable rate mortgage? Historically people who have taken the variable rate have done better than those who took fixed rates. Major drawback is that not everyone can handle or has the ability to endure the payment fluctuations. There is less payment security with a variable rate, but you make up for it in interest savings. You need to decide what is important to you, security or savings.
There now have 4 terms for variable up from just 2 in the past. We have 1, 3, 4 and 5 year terms. There are also variable and capped variables along with open variables. Keep in mind when you see an open variable, there is always a premium for an open term.
What is a capped variable? – What a capped variable is the lender with charge the interest rate based on prime less something. The payment is based on a higher rate, usually the posted rate, and this will not change. When the prime is low as it is now the amount of interest charged is minimal. With the prime rate raising the amount if interest charged rises and less goes directly to principal. Capped variables are at very few lenders.
If you plan to take a shorter variable 1 or 3 years then you are banking on deeper discounts when the term comes due.
What are 5 year Cash Back Mortgages? – These are still an option for people who have not been able to save up a minimum 5% down-payment. Drawback is that you pay a higher rate for the 5 years of the mortgage and if you would like to refinance you may have to payback part of the cash received upfront. If you can find a family member to gift you the amount then you will pay less interest. The down-payment on this type of mortgage is not free!
What is a 5 year No Frills Mortgage? – If you do not intend to use the pre-payment privilege on your mortgage these types of mortgages can offer lower interest rates. Less than 5% of mortgages actually have people use the pre-payment option.
What is a Hybrid Mortgage? – A Hybrid mortgage is part fixed rate and part variable rate. This gives a borrower the best of both worlds. Part variable so they can benefit from the lower rates and part fixed so they can also have the peace of mind of knowing what their payment is! The variable portion can be converted to fixed if so desired.
What are the HELOC rates? – Home Equity Line of Credit or line of credit rates have remained stubbornly high while the variable rate mortgages have dropped. We have rates now in the prime plus .60%.
* Please always bear in mind that the replies above should only be used as a guide and not taken as recommendations for any particular products. Do not hesitate to consult the Mortgage Girl team. We will be delighted to help you decide the best course of action.
Rates quoted are subject to change without notice. OAC and E&OE