Should I go short or long; fixed or variable with my mortgage?

“I wish I had an answer to that, because I’m tired of answering that question.” – Yogi Berra

Number 3 on our list of things on which Canadians waste the most money is 5-year fixed mortgages.

They are marketed as being safe and a good protection against a sharp rise in interest rates. The reality, though, is that they are nearly always a huge waste money, they limit your flexibility and result in losing your negotiating power for 5 long years.

That is why we call it the “5-Year Fixed Mortgage Trap”.

I am not a mortgage broker, but have researched mortgages and always have strong opinions. The most common questions about mortgages are “short vs. long” and “variable vs. fixed”. Which is better? Canadians often debate this, but studies consistently show that short beats long and variable beats long term fixed.

If it is so obvious, then why doesn’t everyone see it? Longer term mortgages are marketed heavily by banks and mortgage brokers that make far more money on them then short term mortgages. Also, most people are bad at math and may get a general feeling of security from a fixed rate, but they do not do the math on how much this protection costs or the odds that they will lose money.

“Unfortunately, most of the existing folklore and advice is rarely subjected to formal statistical analysis and does not address the probability that a given strategy will be successful.” (Moshe Milevsky) The main reasons commonly used for taking 5-year fixed mortgages turn out to essentially be myths:

3 Mortgage myths about 5-year fixed mortgages:

1. They are safer

A study by Moshe Milevsky, finance professor at York University, from 1950-2000 showed that the average Canadian wastes $22,000 after tax (based on a $100,000 mortgage for 15 years) in their life because they got sucked into 5-year fixed mortgages rather than variable.

If your mortgage started at $300,000, then you can expect to waste $66,000. They also took on average 38 months longer to pay off their mortgage. The chance of losing money over 5 years was 89%. A study by Peter Draper (mortgage broker) comparing 5-year vs. 1-year mortgages from 1975-2005 showed that the 1-year mortgage saved money 100% of the time! How can an 89-100% chance of losing thousands of dollars be safer?

2. Rates may go very high like in the 1980s

I was an accountant for a mortgage company in 1982 when mortgage rates peaked at 22.75%. My first mortgage was a 5-year fixed in 1980 at 13.75%. I thought that I had lucked out, since rates jumped to 22.75% and were back to 13.75% by 1985 when it came due. What I didn’t realize was that, even then, I would have saved money by going variable! Based on Peter Draper’s study, I would have lost money for 2 years and saved money for 3 years. So, even with a huge leap of 9% in mortgage rates in the first 2 years of my mortgage, I still lost money with a 5-year fixed rate!

Also, the odds of a huge rate rise are extremely low. We can’t calculate them, since it has only ever happened in the early 1980s, but the odds must be extremely low. Demographers, like Harry Dent, claim it related to Baby Boomers entering the housing market for the first time, which is a phenomenon we don’t expect to be repeated in the next few decades.

3. Your mortgage payments will stay the same

Most variable mortgages also keep your mortgage payment the same during the term. Many people believe that their mortgage payment will fluctuate with a variable mortgage, but this is also a myth.

Top 4 reasons to stick to short or variable mortgages:

1. Save thousands

On average, you should save 22% of the starting amount of your mortgage and pay it off 38 months earlier. (Moshe Milevsky) In the Toronto area, an average mortgage is $2-300,000, which would be savings of $44-66,000 after tax. That is essentially one full year’s earnings, so the average person works one extra full year just to pay the money wasted by taking 5-year fixed mortgages!

2. Low risk

With variable mortgages, the chance of saving money is 89-100%. Yes, the variable is the low risk!

3. Flexibility

Many things can happen in your life in 5 years that may make it advantageous to refinance. You may want to move, roll in other debt to get the lower rate, make extra payments with no limit or change some terms. Our experience with our clients is that most do some sort of refinancing every couple of years, so being locked in for 5 years is a long time.

4. Negotiating power

The mortgage market is very competitive, so every time your mortgage comes due, you have lots of negotiating power. You can change any term you want, get a free appraisal, negotiate a lower rate, or get an unsecured credit line or other banking service. During the term, you have hardly any power. Remember that when you sign a 5-year mortgage, you sign away your negotiating power for 5 years!

The main reason that 5-year fixed mortgages lose money vs. 1-year is that, in a normal market, they start about 2.5% higher. If you pay 2.5% more in year 1, you need the average for years 2-5 to be more than 3% higher than today’s rate. To be ahead, rates would have to jump by more than 3% and stay there for the next 4 years – a very unlikely scenario.

Conclusions:

  1. Stick to 1-year fixed or variable mortgages. Usually, you should take whichever is lower, but only take variable at a good discount, such as prime -.8-.9%.
  2. Avoid 5-year fixed. Sometimes, they are tempting, but always assume they will end up costing much more, plus you will have lost your flexibility and negotiating power for 5 years. Remember that even when rates leaped 9% in 2 years from 1980-82, short term rates still saved money.
  3. Never take a mortgage term longer than you expect to stay in your current home.

We have been referring people to mortgage providers since the mid-90s and most today have rates below 2%. Most of our clients still have the prime -.85% rate that we had for years before this recent crisis or have our recent 1-year rate of 1.99%.

Today, we are recommending 1-year fixed, not variable. The best variable rates are prime -.4-.6%, but rates are normalizing quickly. We expect that the prime -.85% (or lower) rates will be back soon. We expect that anyone taking a variable today will regret having locked in before the larger discount is available.

Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.  If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com.  You can read his other articles here.

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Excellent! Thank You

Cheers!

H

I would have to agree with your points. The only problem now is that people will be funneled into 5 year rates because it will be easier to qualify.

If people are wanting 1 – 4 year terms or a variable mortgage they will have to qualify using a rate of 5.85% That definitely limits people compared to qualifying at a 5 year rate of 4.49%

You clearly have no concept of risk management. Not everybody has the incredible tolerance for risk that you and apparently your clients have.

I have a 5 year fixed because at the time we renewed the mortgage amount was too high for us and we couldn’t afford any kind upswing in interest. This is unfortunately a pretty common situation although it is avoidable (ie don’t buy too much house).

We have been able to payoff about $150k of the mortgage over the last 3 years and it is now at a very moderate amount. If we were renewing now I would likely favour a variable.

The mortgage pre-payment amount is fairly high (20% of the original mortgage) and we have been moving part of the mortgage to our line of credit (lower interest rate) which has saved a bit of money.

As for Milevsky’s study – can’t you find something that uses newer data? I don’t doubt that his findings were valid from 1950-2000 but come on – the financial industry has changed so much since 2000 that I’m not all that confident his study is all that relevant anymore.

You raise some very valid and interesting points here, but I think Mike’s rebuttal is fair too. Everyone’s situation is unique and sometimes a 5 year fixed is really the best way to go.

Having said that, I am currently regretting our decision to renew for 5 years a couple of years ago when rates were higher. At the time though, the economy looked very poor and we wanted the stability of a fixed rate given that our income is extremely variable.

We ended up being able to pay down quite a bit of the principal since then, but we weren’t sure about that when we renewed. Now we have about 3 years left in our term, but only about 2 years left in amortization. Hindsight is 20/20!

When it comes to a fixed or variable term, variable has proven to be the better course to take, however, risk has to be measured.

I met with a client a few weeks ago that had a lovely (sarcasm) 40 year mortgage at a 1.65%. My first observation, wow, 40 year mortgage at age 50 and retiring in 10 years. Second observation, he couldn’t afford a traditional 25 year mortgage so that lender made him “afford his home” using a 40 year mortgage. Third observation, when not if but when interest rates increase in the next year or two he will be forced to drastically change his lifestyle in order to keep up with his payments. I gave an example of a varaible rate increase of 2% and at that point he would have to sell his home.

Cash flow is essential to deciding which product to choose. Sure, the variable rate mortgage has always proven to be the better way to go, but if your cash flow does not allow you to accomodate for any interest rate increases than there’s a problem.

Get ready Canada, those people sitting with a 30 plus year mortgage and enjoying the joys of a low interest rate will have to adjust their lifestyle (cash flow) in order to keep up with the payments. The kicker is that they can’t even flip into a fixed mortgage because the rates there definitely make their home unaffordable.

Thank you Ed. This was a very thoughtful and well presented post, and extremely informative.

I do think that there was a historic blip that occurred recently with the credit crunch, where variable rates climbed but the fixed rates were very low still.

At the time, I bought my house about 9 months ago, the variable rates were prime + 0.5% (or 2.75% and that’s after alot of shopping around), while we got a five-year fixed for 3.4%. So the spread was 0.65%. Considering where the rates are going, this was a no brainer to go for the fixed.

In general, your analysis is correct, and I think going variable is the route to go and I will certainly relook at the 1 year-fixed term contracts, but I think we just went through an abnormality in credit lending which means the studies quoted earlier aren’t entirely relevant. We’ll see how it plays out, as I’m sure I’m saving money over the longer term with a five-year fixed in this very unique circumstance.

Ugh, where was this article two weeks ago when I got a 5 year at 3.84% fixed, I miss my 1.9% variable!

I liked this article. We’ve been enjoying a prime minus 80 mortgage for almost 5 years, and we’ve saved a lot. (I really should crunch the numbers and figure out exactly how much we have saved!) With regards to your myth number 3, our payments have fluctuated with rate changes, so I don’t think it would be safe for someone taking on a variable rate mortgage to assume their payments won’t change when rates change. Our mortgage is up for renewal in 2 months, and the low fixed rates of a few weeks ago are being held for us – I’d still rather go variable again, but I’m hoping the spread will increase in the next couple of months! It’s a bit of a tough decision when fixed rates are so low right now.

I’m not sure myth 3 is entirely true. When I was shopping around for mortgages, the Big Banks had variable mortgages with fixed payments, but everyone else was offering variable mortgages with variable payments.

When I went to get a mortgage on my new home nine months ago, all of the banks were “offering” prime + 0.75, I was uanble to negotitate a “prime minus” mortgage. Interest rates were low and have risen a lot more than the prime rate. I decided to go with a long fixed rate mortgage despite being good at math and aware of the studies, and got a low enough rate that I fixed in for the entire life of the mortgage. Was this foolish? Time will tell, but this article did not convince me. During Milevsky’s study, how often did interest rates as low as they possibly could, so that they would have to rise? During how many of those years was it impossible to get a “prime minus” mortgage even with a good FICO score? I saved money by paying off the prinicipal, getting a good rate, getting a shortish mortgage with an accelerated weekly payoff. These factords make a bigger difference than, at best, saving 1% or so on the decent rate I eventually got. This article liberally applies a $22,000 savings to every year and is cavalier in assuming savings of 89-100% — but maybe things are differnt when rates are at a historical low and de facto minimum. I don’t want to renegotiate my mortgage every two years, and a prime – 0.85 rate was impossible to get at the time I got my mortgage.

variable is a the way to go if you can handle fluctuations, I know several people who bought housing in the last 2 years and are barely making it on a couple of % mortgage, what will happen to these people when prime hits 5-6% and yes, it will get there, sooner then most think.

I am a CFP and Mortgage Broker so I know a bit about this as well. I give my clients all the options including variable rate mortgages that “cap” at the 5 year fixed rate posted at the time they took out the mortgage and 50/50 mortgages where half the amount is at the 5 year fixed rate and half at the variable rate. You are correct that some mortgage brokers go for the 5 year fixed for higher commissions but the Financial Planner in me is always trying to save my clients money and give them prudent and unbiased advice. Like Mike, I suggest a strategy that uses the straight interest of a HELOC to lower the effects of amortization and reduce the time needed to pay off the mortgage and save a ton of money in payments.

I think most variable rate mortgages have fluctuating payments. I know that ING Direct changes the monthly payment every 3 months if there were any changes in prime. For those who are afraid of higher payments that they can’t afford in future years, they could consider this strategy: calculate the fixed monthly payments you would make if you had chosen a 5-year fixed. Then every time you make a mortgage payment, calculate the difference between that payment and the hypothetical payment. Invest that difference in a short term GIC or high interest savings account, so that you’re effectively paying the 5-year payment amount but putting some of it aside. In the future, if prime really does get to 6% in less than 5 years, then withdraw the difference from the savings account. Having the lower mortgage rate initially means you’ll pay down more of the principal, AND have built up a decent savings account that’s earning interest. It’s still possible that the savings could run out, but as Ed points out, the variable rate statistically has a much better chance of ending up costing you less! The biggest problem with this strategy is that people can’t seem to leave those savings alone (I really needed a new car and that money was just sitting there…)

All fine and well… but there is certainly an aspect of risk management that is very important in this and it is hard to quantify. My family was wiped out in the early 80’s because of high interest rates and a variable rate mortgage. The payments balooned so much that we were unable to service them and ended up walking away from our home and having to start all over again after the dust settled. Price of locking in and avoiding that destructive trap? Worth every penny.
Easy to say that rates won’t go back to 20% when we’re at historically low rates… but no one can predict the future and I’d rather not roll the dice on something this important. Even a 5% chance of financial ruin is more risk than I’d like to entertain when I can pay to avoid that collapse. Trying to sell a house when rates are that high will result in wiping out any equity you may have built up, since house prices and rates are negatively correlated.
Many economists are predicting rates increasing by 3% over the next two years. Locking in now would result in interest savings over the next 5 years if this turns out to be the case. And I believe that 3% is just the beginning. We’re entered a new era of increasing interest rates as governments scramble to cover their balooning debts. Caveat emptor!

Ed, Great post that shows the pros of the variable rate.

Best decision I have made in finance (allows me to save money on my mortgage).

Great point about the the rules involved (heavily discounted variable – prime, not flipping house).

I never saw the math before for 1-year rates (other than the time involved it is a great idea).

Thanks.

I think a significant problem is that people buy too much house. I would gladly choose a more modest house and a variable rate. If you are at the top of your affordability that’s a problem. What do you do when you have to renew your mortgage in 5 years and the rates are higher?

I have seen two people living in a 6000 square foot home with the heat almost off to reduce expenses. My family lives quite comfortably in 800 square feet and we also heat it :)

It’s not a dream house but it is warm and dry. There are no Scarlett O’Hara staircases and ensuite bathrooms or walk in closets but it took five years to pay off.

Mike said:
“the financial industry has changed so much since 2000 that I’m not all that confident his study is all that relevant anymore.”

I was wondering if his point would apply to other areas of finance: EMH, fundamental/technical analysis or the statistics they use in the insurance business. What about CAPM, modern portfolio theory and diversification?

If the financial industry is ever-changing, could it be that these theories have become obsolete?

I agree with the writer about variable over fixed.

Especially now we are being bombarded with big bank ads and “analysis” pieces in the financial section of every published rag, that the sky is falling and the interest rates are going to skyrocket.

What most people fail to understand is that by selling you a five-year fixed rate a bank, has made 100% sure that they will not lose money on this mortgage, in case the prime rate were to rise as they are predicting.

The fact that they push this product down people’s throats via scare tactics, and always downplay the variable rate, shows that the variable rate is good for the consumer, and the bank makes less money there.

I will stay variable till the day my home is paid for.

So what does “fixed payment variable” mean other than it being an oxymoron? Doesn’t it just reduce principal repayment to compensate for higher rates, or can someone clarify if there is some sort of magic going on?

I can’t figure out how a variable rate at 2% changing to 5% won’t result in higher payments, even at 0 principal repayment.

@jesse
Some variable rate mortgages are set up so that your payment will remain the same, regardless of interest rate movements. If rates drop, more of your payment will go towards principle, and your amortization will be reduced. If rates rise, less of your payment will go towards principle, and your amortization will be increased. With these types of mortgages, your payment amount will only be changed if rates rise to the point where the payment no longer covers the interest being accrued.

Myth # 3 is misleadingly incomplete. Yes you can get fixed payment variable rate mortgages, but you trade a fixed payment for a fluctuating amortization period. i.e. If the interest goes up, less of your payment is applied to principal and it can end up taking you longer to pay of your mortgage than you planned. This in itself is a risk.

@YYC81: thanks for the clarification. So I just increase loan amortization period when rates go up to reduce monthly payments. In other words I save less. Hardly a benefit at all in my books as I pay interest for a longer period.

Variable rates are best used as long as your time horizon matches the investment. If we’re talking about a 40 year investment there needs to be some provision for pro-cyclical debt ratios: the very time you should be paying down debt is exactly the time when you can’t afford to do so due to high interest rates. This is part of the reason why there is a “discount” for shorter term rates and why, contrary to the thesis in this post, rational Canadians pay a premium for stability.

One wonders why companies take out long term debt at all.

I’m one of those that let myself get trapped–2.5 yrs ago was offered “staff” rate and went for it. A wonderful follow-up article would be “What to do next for those in the trap”. I’ve used Prof. Milevsky’s calculator to see if it is worth it to break the mortgage, but it doesn’t seem so in my case. Should I at least be transferring that annual lump sum amount to my HELOC even if it will sit there for a while?

I know this doesn’t apply to most of the scenerios discussed here of people barely making their payments on their low interest variable rate mortgages, but I know in our situation at least it has allowed us to make significant extra payments to our mortage.

Every two weeks with the mortgage payment we take the difference between what our payment is and what it would be using our banks current fixed rate and put it away. When the pot hits a certain value ($500 at the moment) we make an extra payment. This way we’ve gotten used to paying more in case rates do go up. As well, these extra payments are straight premium and not premium plus interest like they would be if we actually were paying that higher interest rate.

But yes, it does come back to the idea of not buying too much house. Obviously this wouldn’t work if we HAD to take the low percent variable mortgage in order to make payments.

Elbyron: you’re better off just setting your payment to the same as the 5 year fixed amortization than saving the spread in a GIC. Mortgage prepayments are like tax-free savings, whereas GIC interest is taxable. If rates rise such that your variable payment is higher than the 5 year fixed payments were (despite your early principle pre-payments), and you can’t adjust your spending accordingly, just get a HELOC.

The key is to not buy too much house.

This is so true, people always end up paying more for fixed, affording themselves the “peace of mind” that costs are capped.

cheers

Great article! Well done.

When I entered the business I was surprised to find out that variable rate mortgages that cap at the 5 year rate exist, same with 50/50 mortgages. Nobody here seems to have an opinion on these as options for those who would like a lower variable rate but don’t want to be caught with their pants down if we see significant rate hikes over the next few years.

Hi Mike 4P & Sarlock,

Let me address the issue of risk. If you take a 5-year fixed or a 5-year variable, in both cases you can make exactly the same payments for the entire 5 years. If interest rates rise, in both cases, you are still making the same mortgage payment. Your mortgage comes due at the same time.

It is correctly pointed out by some here that some variable mortgages change payments periodically, but our contacts are mainly with the major banks and their mortgage payments stay the same for the entire term of the mortgage. If rates rise, you just pay less principal.

The only major difference is that with the variable you have a 93% chance of having a lower mortgage balance at the end of the 5 years.

In a normal interest rate environment, the variable rate is roughly 2.5% lower than the 5-year fixed. So, then the fixed cannot possibly save money without a rise in rates of at least 3% and rates staying high for years.

I would suggest that the 5-year fixed is not the low risk option. The low risk option is the 5-year variable (with a fixed payment).

Moshe Milevsky’s study still applies. We have been recommending either variable mortgages or 1-year fixed for about 15 years and I’m sure we saved money over the 5-year fixed for all of the last 15 years.

Ed

Hi Jason,

You’re right that the spread between variable and 5-year fixed was very low a year ago. That is why we always look to see whether variable or 1-year is better.

Last year, we were getting 1.99% on a 1-year fixed. That was .76% below the variable and 1.41% below the 5-year fixed. Those mortgages are starting to come due now and rates are still low, so those clients will have at least 2 years at rates much lower than the very low 5-year fixed you took that looked so good.

Now, we are getting 2.15% on a 1-year fixed. This is only slightly up from last year’s 1.99%.

My point is that the 5-year fixed often LOOKS good, but if you take the best deal between 1-year fixed and variable, you can virtually always save thousands.

We would suggest to essentially never even consider the 5-year fixed. Only look at variable and short term fixed.

Ed

Ed, here’s a question for you: why do large corporations issue long term debt? By your argument, wouldn’t they do better by exclusively issuing short term debt instead?

How did Moshe correct for inflation? I would hate to find out that those 22 thousand dollars are all nominal in nature. How would that change the picture?

Also, Moshe provides some caveats, namely that inverted yield curves and oil price shocks are exceptions to the rule – these are the exceptional economic circumstances where the opposite holds true.

http://www.ifid.ca/pdf_workingpapers/WP2001A.pdf

Pages 14-15

Hi Jay,

Your point sounds logical but is not supported by the study. In fact, very shockingly, the variable rates have always saved money during rising rate environments.

During the 1950s and 1960s, rates were low and rose steadily. During that time, there was a wider difference between the variable/short term rates and the 5-year fixed.

In general, the difference between the short term/variable rates and the long term fixed is wider during periods when rates are expected to rise.

Interestingly, during these periods of low rates from 1950-68, if you ever took a 5-year fixed, prime stayed below that rate for all of the next 5 years. During that time, variable saved money every single month of every single mortgage!

The really interesting point is that the only times that 5-year fixed saved money over variable where 1987-88 and 1992-4 – both of which were periods of FALLING rates. Both periods had falling rates where an unexpected economic shock resulted in a small rate boosts that only lasted a few months.

During periods when rates are falling, there is usually a smaller difference between the short and long term rates, so that has been the only times when a short term, surprise rate bump could result in the 5-year NOT losing thousands of dollars.

Ed

Hi Again, Jay,

I was thinking about your comment about not wanting to renegotiate your mortgage every 2 years. Why not???

We find this to be one of the weirdest points of all. One of the main ways people get sucked into 5-year fixed mortgages is because of the bad service on mortgage renewal. Banks actually make tons of money because people dread renewing their mortgage – so they agree to pay thousands more every year!

We do all the negotiating for our clients and teach them the benefit of negotiating. It is fun and one of the most profitable activities you will do in your life.

Renegotiating usually takes only about an hour, including meeting to sign papers. Our contacts often go to meet their clients, so renegotiating could take as little as 10 minutes.

Meanwhile, most mortgage holders in the Toronto area have mortgages of $2-300,000, so in normal market conditions they waste $2-5,000/year because of their 5-year fixed mortgage.

So, let’s do the math. I spend an hour renegotiating my mortgage and therefore save $2-5,000/year for the next 5 years. So, I made $10,000/hour after tax for my 1 hour of work. That has got to be one of the most profitable hours of my life!

Why would you NOT want to renegotiate?

It is also fun!

We constantly negotiate between our various mortgage contacts. We try to always have the best possible rate for the term we are recommending at the time. So, our clients can just take our referral. (We still offer “Ed’s Mortgage Referral Service offered on this site for MDJ readers, as well.)

But for those that want to negotiate on their own, we just tell them the rate we are getting and they ask their bank if they will match the rate, and the terms.

There is no need for bluffing or playing games. Just see if your bank will match the best available mortgage. If you will actually move the mortgage if they don’t match, then it is amazing how often they will match. It is quite fun to do this process (when you know what is reasonable to ask for)!

Ed

Hi Lynn,

Great suggestion to write an article about “What to do next for those in the trap”.

The calculation of whether or not it is worth it to pay the penalty to renegotiate your mortgage now can be complex. You lose the cost of the penalty, but you save interest rates (and need to make a reasonable assumption about this). You may also be able to save money be refinancing other more expensive debt or using some to invest (perhaps as a low cost RRSP loan).

We are experts in the Smith Manoeuvre and have found it beneficial for many clients (because it helps them save for retirement without using their cash flow), so if that is an option, then the calculation should take into account a reasonable estimate of the Smith Manoeuvre benefit of being able to start now instead of waiting till your due date.

So, taking all these factors into account, it can be complex to figure out whether or not paying the penalty to get out of your MORTGAGE TRAP is worth it or not.

I already wrote the article, though, Lynn! It is on MDJ: https://milliondollarjourney.com/ed-rempels-picks-for-the-best-smith-manoeuvre-mortgage-ii.htm . If you answer the 10 questions and email me, one of our team will do the calculation for you and contact you to give you our recommendation.

Ed

“With such confusion in the marketplace, these days even Prof. Milevsky is leaning somewhat in favour of the five-year closed fixed-rate mortgage.”

http://www.canada.com/business/fp/There+variables+variable+rate/2059901/story.html

Very very clear and easy to understand artile Ed.
When I first thought of getting a mortgage I did what the majority of people do, automatically thought that fixed would save me money. I am all about planning every penny out, and saving everything I can (while gaining the most profit possible).
So being prepared to pay a ‘slightly’ higher fixed rate, to guarantee that if interest rates were to rise I would be ‘safely secure’, made sense to me… at first. But when a friend (that is a mortgage broker) recommended that I get variable, and a 5-year variable at that, I was skeptical.

The way you state the simple facts here, make it obvious that getting into a 5-year fixed is just as bad as buying a first-to-die policy. Always do the calculations, and if you don’t know how you should learn; before signing anything.

Sure everyone makes mistakes, and ‘most’ people learn from their mistakes, but many mistakes in life can be avoided. And learning from other people’s mistakes can help you out in an extraordinary way!

Great article.

I find it kind of funny that your article simply points out that variable rate mortgages are statistically proven to save you money. The banks are selling the illusion of safety at a considerable profit margin. Unlike all of us they have risk management specialists helping them set the rates for 5 years so that they are guaranteed to make money.

Ironically we now all have to qualify for the 5 year fixed rate mortgage when buying a property.

The truth is that most people will almost always make emotional buying decisions then use their feelings to argue the statistics.

I read an article a while back about child safety seats which we now have to buy by law until our kids are practically in high school. Basically the study showed that there was absolutely no benefit to any child safety seat past the age of 2. In fact if bad fitting or poorly made seats were taken into account injuries went up. So statistically there were more injuries past the age of 2 since these additional child seats were introduced. It was a very large study over a considerable period of time. Still the responses were quite irrational. People wanted to hold the belief that there was some benefit in spite of evidence to the contrary. Numbers don’t lie.

Oh man, where to start. As usual, Ed makes grand pronouncements based on general trends without looking too hard at the details.

First, Moshe Milevsky has updated his research several times since the study Ed cites, and he currently is “leaning somewhat in favor of the five-year closed fixed-rate mortgage”.

Second, using more realistic assumptions about fixed vs variable rates (i.e., using discounted instead of posted fixed rates), there were an awful lot of periods (at least 6 over the last 40 years) where the 5-year fixed would have been better. Given that prime has no potential to drop and, until recently you could get fixed for under 4%, there is a very high likelihood that we are in (or just left) one of the periods where fixed would be better.

I actually think that for the most part Ed is right. However, I think the people who locked in a 5 year fixed rate at 3.69% are going to end up ahead of the variable rate guys over the next 5 years. Read my more detailed analysis of it:

http://financialuproar.wordpress.com/2010/04/21/are-variable-rate-mortgages-always-better-than-fixed/

I’m a lawyer so I have to agree that 1yr term mortgages are fantastic! More re-fi work for me!

Financial Uproar – You hit the nail right on the head. Stating precisely what I intended to demonstrate.

All-in-all – let’s resume in 5 years and compare figures when my 3.65% fixed rate expires!

There is rarely a catch-all – this applies to the eternal fixed vs variable debate. In five years, I’ll likely tend to slip toward variable.

Hi bob,

Part of why I am passionate about this is that most people don’t have a lot to spare and yet waste so many thousands of dollars on 5-year fixed.

The other part is just from experience of all the clients that have had to pay the penalty to get out of a 5-year fixed. We have probably had 100 clients in the last 10 years pay the penalty. They are struggling with high payments or need to refinance for one of many possibly reasons.

So many people have been trapped!

We feel for all the people we’ve met that thought they were doing something safe, but then something changed in their life – and now they are locked in.

Over the last 15 years talking with clients about their mortgages, we continually have run into people paying very high rates, or people that need/want to refinance and are trapped.

The most common situations are:

1. They can save money by paying the penalty and refinancing now. We do the calculations in detail for clients or potential clients about whether or not it is worth it to pay the penalty and refinance, and it is surprising how often clients can save money paying the penalty. From our experience, most 5-year mortgages are worth paying the penalty to get out of at least part of their term.
2. They have accumulated debt at high rates that they are struggling to pay off and need to refinance.
3. They have a mortgage term longer than they expect to be in their current home, so they will have limited negotiating power with the new home. “Blend-and-extend” is a disaster for clients.
4. They want to use their home equity for investment, such as the Smith Manoeuvre, but have the wrong type of mortgage.
5. Their income has plunged and they want to cut their payment to the absolute minimum.
6. Their income has jumped or they received a large bonus and want to pay much more than the minimums allowed.

The extreme has been 2 clients we have met in the last year that are on the verge of bankruptcy because their were “raped” (the client’s words) into taking a 7-year mortgage at 6.99%! The penalty is $35,000 and definitely worthwhile to pay, but the client cannot come up with the $35,000. One had a big pay cut and now must struggle on the edge of bankruptcy for 4 more years! They are truly trapped!

This is why even the thought of a 5-year fixed scares me! How can anyone know that their life won’t change significantly in the next 5 years? If they have a huge change in pay, run up other debt, want to move, or want to use their home equity for other purposes (such as saving for retirement), they will be unhappy being trapped for 5 long years.

My mental picture of a 5-year fixed mortgage is a jail cell – you are trapped with limited flexibility for years and you surrender your negotiating power for that whole period.

Because of the major advantages of flexibility and because we enjoy negotiating, plus all the extra goodies you can negotiate whenever your mortgage comes due, we really prefer short term or open mortgages.

A few comments on this blog seem to assume that the 5-year mortgage is the default, so if their forecast is close, then just go with the 5-year.

Our view is the opposite. If it is close, why would anyone lock themselves in and just give up their flexibility and negotiating power for nothing? We would not consider locking in unless we had a strong opinion of significant savings by locking in. If it looks close, the 5-year fixed would be the last choice.

Our default would be either a 1-year fixed or a variable (preferably variable open). Those would be the terms we would look at, unless there are very strong reasons to consider anything else.

Ed

Hi bob,

Regarding Moshe Milevsky’s recent article, he says he may be leaning toward fixed, but that was last year when variable were nearly at prime +1%. I wouldn’t lock in a variable at that rate either.

That is why it is usually worth considering BOTH the 1-year fixed and the variable.

We were getting 1.99% for much of last year and are now up to 2.15%. That is almost definitely much better than variable today. With the variable, you can get prime -.5%, or 1.75%, but it will float up in the next year.

More significantly, though, if you lock in prime -.5% for 5 years, you give up the very likely discounts of prime -.85% that should become available soon as rates normalize again.

Ed

Hi Play with the Odds,

I agree. Let’s look at this again in 5 years and see which was better. We can compare your 5-year fixed you mentioned at 3.65% vs. the best of 1-year fixed or variable.

What date did you take your mortgage?

I assume you took your 5-year fixed last year. So, the alternative would be 1-year (not variable) at 1.99%.

So, year one goes to the short/variable team by 1.66%!

Let’s see how it plays out.

While 3.65% may look good, our issue is that we don’t really think of that rate as very low. We have been recommending either 1-year fixed or variable for the last 15 years. In the last decade, we were between 4-5% almost all of the decade. There were 2 previous periods between 3-4% and there was only one brief period about 2 months when we drifted slightly above 5%.

Without an actual calculation, I would say our average over the last decade was between 4.25-4.5%. So, at 3.65%, you are only a bit lower than an average rate – say roughly .5% below the average of the last decade.

Today, we have “historical” low rates, well at least the lowest since the 1950s. So why not take a real low rate and enjoy it for a while before going back to normal rates?

Ed

Hi Ed,

I locked in for 5 years in March 2010. Though I agree the trend of the past decade has been fruitful for the frugal mortgager, it also extremely pertinent to point out that trend of 4-5% from commercial banks over the past decade is well below the trend of that past 75 years of 6-7% on central bank rates.

Here’s reference from the central bank, for your calculations:
http://www.bankofcanada.ca/pdf/annual_page1_page2_page3.pdf

I have no doubt that I’ll be slightly behind for this coming year (quite obvious considering the 2.25% 1-year fixed TD is now offering), but am fairly confident that I will be close to even the year after, and begin the climb to pulling ahead when the 25th month ends. I don’t know analysts who wouldn’t agree that this is what the odds favour.

Now that the option for 3.65% is long gone, I’d agree though, that attaching yourself to a variable rate or a 1-year fixed is likely the best bet for a primary residence at this time.

Now that we’re all simply science experiments, I’ve marked March 2015 in my Google Calendar with reference to this article. Hope we’re all still active come that time. Actually, I’ve marked March of every year for the next five years so we can review the speculation.

Hi Ed,

I agree that in most instances VRM are advantageous (I have one myself), but as usual, my issue with your posts is that in “trying to educate”, you generally fail to offer both sides of the equation, which ends up doing a disservice to people who are actually trying to educate themselves.

Here, you say: “Avoid 5-year fixed. Sometimes, they are tempting, but always assume they will end up costing much more”.

That simply is not true. The do NOT always end up costing much more. There were at least 6 occasions over the last 40 years (and I’d argue we just left another), where a 5-year fixed rate would have cost you less than either a VRM or a 1-year fixed. By pretending those situations never exist, you are misleading people.

You also neglect to include other real world considerations like risk tolerance. Some people simply cannot afford to take the chance that rates will rise above the 5-year fixed cutoff. It is an insurance policy — we all get “raped” (to use your client’s term) by life insurance, but we pay it anyway because on the (hopefully) rare occasions we need it, we really, really, need it. A five-year mortgage is similar; you pay a premium for certainty. And certainty is not without value.

You did the same thing in your Myths of the Stock Market post where you presented a hypothetical equities return without qualifying it with information about what actual investors make or stage of life, or portfolio allocation, etc.

Don’t assume that your clients are all fools — give them ALL of the relevant information, and they will make the right decision.

Bob, I agree with your comments but I don’t think it is your call to tell Ed how to run his business.

Ed is a salesman, not an educator.

I’m not telling Ed how to run his business. I’m just trying to point out the missing links in his posts which, he has said in the past, are meant to educate . . .

So, yeah, I guess I should have used he word “readers” instead of “clients”. My apologies.

@bob: You said:

“You also neglect to include other real world considerations like risk tolerance. Some people simply cannot afford to take the chance that rates will rise above the 5-year fixed cutoff.”

So when their 5 year term is up and mortgage rates skyrocket to 10%, 15% or 20% like in the 80’s what are they going to do? What’s the difference if you can’t afford your house at year 3 or year 5?

Problem is, people are very bad at evaluating risks. A 5 year fixed is almost always more risky if only for the fact that people don’t know where they will be in 5 years and the flexibility is so important.

Fact is, the $ amount you are paying to the bank is what counts. People are to obsessed with interest rates and amortization periods. You need a good strategy that works for your situation that lets you pay as little extra $ as possible. That includes pre-payment options, the ability to convert interest payments to tax deductible interest with the smith manoeuvre etc…

You should pay your VRM off as if it were at the fixed 4%-5% rate where the additional % points go directly to pay off principle. The PV of your mortgage will be lower after 2-3 years than it would be at year 5 with a 5 year fixed. And yes, most banks do not adjust your payments if interest rates go up until your VRM term is up.