Crunching the numbers for fixed and variable mortgages

The age-old debate of fixed versus variable mortgage rates has really heated up recently with the 0.5% increase in the prime rate.

I am a variable fan myself, for several reasons. One of the most important reasons is the flexibility variable rates afford. If I want to pay my mortgage in full, I am looking at a three-month interest penalty, end of story. I can work with that.

I talk to clients who are in fixed rate mortgages who are looking at penalties of $12,000 or $17,000 because they have to sell and will not be replacing their current mortgage. That hurts.

Over the last few weeks I have run calculations for clients to show them the differences between choosing variable and fixed rates.

We often get hung up on the percentage rate, as opposed to considering all of the implications of going with one rate or the other.

Here are some things to think about:

• What is the difference in monthly payment?

• How much will my payment change when prime changes?

• How much interest am I paying?

• What would my penalty be if I were to break my mortgage?

The Government of Canada has a great tool for running calculations. I ran three scenarios to consider, using the same mortgage amount and amortization but changing the interest rate.

Presuming a mortgage balance of $400,000 and an amortization of 25 years, here are the numbers for a five-year term:

Scenario 1 – Fixed rate at 3.99 per cent:

Monthly payment: $2,101.91

Principal paid: $51,845.03

Interest paid: $74,269.77

Balance at five years: $348,154.97

Scenario 2 – Variable rate at 2.2 per cent

Monthly payment: $1732.66

Principal paid: $63,515.91

Interest paid: $40,443.54

Balance at five years: $336,484.09

Comparing these two scenarios, at the end of five years you will have paid $22,155.35 more in mortgage payments had you chosen the fixed rate option. Your mortgage balance would be $11,670.88 higher and you would have paid $33,826.23 more in interest.

This is the cost of choosing the security of a fixed rate. This doesn’t even factor in the potential difference in penalty if for some reason you had to break your mortgage early.

But, as for that security, what if rates go through the roof? Then what?

I ran another set of numbers.

Let’s assume that prime increases by a full 1%. What happens then?

The challenge in running this scenario is that historically prime doesn’t increase a full 1% at a time. This happens gradually. So full disclosure, these numbers are just to give you an idea of the cost.

Scenario Three – Variable rate at 3.2 per cent

Monthly payment: $1934.27

Principal paid: $56,797.91

Interest paid: $59,258.19

Balance at five years: $343,202.09

Comparing scenarios one and three, at the end of five years, you will have paid $10,058.70 more in mortgage payments had you chosen the fixed rate option. Your mortgage balance would be $4,952.88 higher and you would have paid $15,011.58 more in interest.

When prime changes by 0.25%, with these figures your payment would increase by $49.26 monthly.

If you choose the fixed rate option, you are guaranteed your payment will be $369.25 higher monthly as compared to the starting variable rate of 2.2 per cent. It will take almost eight rate increases for you to be at the break even point. And because historically those rate increases don’t all happen at once, it would take much longer before you were backwards with your interest cost.

Realizing this is a lot of numbers to throw at you, and that every situation is unique, I just wanted you think a bit about how your rate choice will affect your mortgage.

What I suggest for my clients who are choosing variable rate terms is this. Look at what the fixed rate payment would be and consider that amount to be your regular monthly payment. Put that amount aside monthly into the account your mortgage payment comes out of.

Don’t touch the extra funds that accumulate in the account. This way when prime increases you won’t feel like you are taking a hit. You are used to making a higher payment and as a bonus you already have a buffer in place.

If, at the end of your term you have a nest egg built up, apply it as a principal payment to further reduce your mortgage balance. It’s a win-win.

This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.