Calculating the Numbers for Fixed and Variable Mortgages – The Mortgage Gal
The age-old debate over fixed versus variable mortgage rates really intensified recently with the 0.5% increase in the prime rate.
I myself am a variable fan, for several reasons. One of the most important reasons is the flexibility offered by variable rates. If I want to pay off my mortgage in full, I’m looking at a three month interest penalty, end of story. I can work with that.
I talk to clients who have fixed rate mortgages and are looking at penalties of $12,000 or $17,000 because they have to sell and will not replace their current mortgage. It hurts.
Over the past few weeks, I’ve been doing calculations for clients to show them the differences between choosing variable rates and fixed rates.
We often dwell on the percentage rate, instead of considering all the implications of going with one rate or the other.
Here are some things to think about:
• What is the monthly payment difference?
• How much will my payment change when the prime rate changes?
• How much interest am I paying?
• What would my penalty be if I broke my mortgage?
The Government of Canada has an excellent tool for performing calculations. I ran three scenarios to consider, using the same mortgage amount and amortization, but changing the interest rate.
Assuming 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%:
Monthly payment: $2,101.91
Capital paid: $51,845.03
Interest paid: $74,269.77
Five-year balance: $348,154.97
Scenario 2 – Floating rate at 2.2%
Monthly payment: $1732.66
Capital paid: $63,515.91
Interest paid: $40,443.54
Five-year balance: $336,484.09
Comparing these two scenarios, after five years you will have paid $22,155.35 more in mortgage payments if you had 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 take into account the potential difference in penalty if for some reason you were to terminate your mortgage early.
But, as far as this security is concerned, what will happen if the rates explode? So what?
I ran another set of numbers.
Suppose the prime rate increases by 1%. What happens then?
The challenge in executing this scenario is that historically the former does not increase 1% at a time. This is done gradually. So full disclosure, these numbers are just to give you an idea of the cost.
Scenario three – Floating rate at 3.2%
Monthly payment: $1934.27
Capital paid: $56,797.91
Interest paid: $59,258.19
Five-year balance: $343,202.09
Comparing scenarios one and three, after five years you will have paid $10,058.70 more in mortgage payments if you had 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 the prime rate changes by 0.25%, with these numbers, your payment would increase by $49.26 per month.
If you choose the fixed rate option, you are guaranteed that your payment will be $369.25 more per month than the starting variable rate of 2.2%. It will take you almost eight rate increases to break even. And because historically these rate increases don’t all happen at the same time, it would take a lot longer before you roll back your interest charges.
Knowing that there are a lot of numbers to throw at you and every situation is unique, I just wanted you to think a bit about how your rate choice will affect your mortgage.
Here is what I suggest to my clients who choose variable rate terms. Look at what the fixed rate payment would be and consider that amount as your regular monthly payment. Set aside this amount monthly in the account from which your mortgage payment originated.
Do not touch the extra funds that accumulate in the account. That way, when the premium goes up, you won’t feel like you’re 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 accumulated a nest egg, 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.