With the recent boom in real estate prices you can pretty much guarantee everyone is carrying more mortgage debt than ever. In 2001, Canadians collectively held $447.2 billion dollars of mortgage debt. That was a 156% increase over 1982 data when Canadians held $174 billion of mortgage debt. Here’s the perspective: while mortgage debt increased 156% from 1982 to 2001, disposable income only increased 42%. That means more debt to income than ever before. This trend has to change so this article revisits the issue of going with a variable rate mortgage or a fixed rate mortgage.
Variable vs fixed rate mortgages
The debate between variable versus fixed rate mortgages has gone on for a long time. In theory, when interest rates fall many experts will argue that variable rate mortgages will save you interest. However, in rising interest rate environments, fear of never ending increases causes people to lock into 5 year fixed rate mortgages. Most recently, Moshe Milevsky, a Professor of Finance at York University has updated some research showing that mathematically, the variable rate is the better strategy over 88% of the time.
In Milevsky’s research paper, he shows that Canadians could save $22,000 of interest payments for every $100,000 of mortgage debt over a 15-year amortization by going with the variable rate option. He used interest rate data from 1950 to 2000 to make his point.
Pay fixed dollar payments on a variable rate
While many people avoid variable rate mortgages because they don’t like the idea of variable or changing payments, the secret to using a variable rate is to make payments as if it were a fixed rate payment. Currently the average rate for 5 year fixed rate mortgages is just under 6.9%. At the same time, the average rate for variable rate mortgages is about 1.0% lower at 5.9%. This current spread of 1.0% between 5 year fixed mortgages and variable mortgages is not uncommon.
For every $100,000 of borrowed money under a 5 year fixed rate at 6.9%, the monthly payments would be $694.25. Over a 25-year amortization, you would pay a total of $208,275 in payments of which $108,275 would be interest. With a variable rate of 5.9%, you could have lower monthly payments of $633.87 on the same $100,000. However, instead of going with lower payments, you would be better off to take the variable rate at 5.9% but make monthly payments of the same $694.25 under the fixed rate option. By paying the $694.25 per month at the lower 5.9% interest rate, you would pay off the mortgage in less than 21 years as opposed to 25 years). More importantly, you would save $35,917 in interest over the amortization of the mortgage. Blend the security of a fixed rate with the benefit of the lower interest.
Home Equity Lines of credit (HLOC)
One of the fastest growing trends in the mortgage arena is the explosion of home equity lines of credit. In my mind, HLOCs are a more flexible form of the variable rate mortgage. Interest rates typically float but your payments are extremely flexible. Although HLOCs give you the ultimate in flexibility, that same flexibility can be very dangerous for two reasons. The first is that with HLOCs, it is so easy to go in the wrong direction accumulating more debt as opposed to paying it off faster. Secondly, it is far too easy for people to make minimum interest payments and avoid paying down the capital.
With mortgage debt growing faster than ever, it’s time for Canadians to get disciplined and start paying down their debts. It’s time for more discipline and less flexibility. You don’t have to look very far south to see what too much debt can do to real estate, the economy and people’s personal finance.