Variable vs. Fixed: A Direct Comparison of Both for Today’s Rising Mortgage Rate Environment

At 1.5 per cent, Canada’s overnight rate is a quarter-point higher today than it was at the start of the week. Traders bet that it will go all the way back up to its “neutral rate,” that theoretical rate where no further rate hikes or rate cuts are warranted, by 2020.

As I’ve written before, the Bank of Canada estimates the neutral rate at 2.50 per cent or more. The market, however, thinks its closer to 2.25 per cent. And that’s a safe bet given:

· Recent levels of consumer consumption and housing investment (which combined accounted for 92 per cent of Canada’s growth since the last recession, according to money manager PIMCO ) are unsustainable — thanks partly to heightened sensitivity to rate hikes by over-indebted consumers, stricter mortgage rules and slowing home equity growth.

· The fact that inflation, unemployment, and growth (the “output gap”) are already at or near the Bank of Canada’s targets.

· Looming trade risk — which could result in meaningful job losses, offsetting the inflationary effects of tariffs.

So, the smart money is on the market being roughly correct in its 2.25-per-cent neutral rate estimate.

Incidentally, Bank of Canada Governor Stephen Poloz puts considerable faith in market estimates. He opined Wednesday, “It’s often said that the bond market is the smartest forecaster that there is, and I happen to think that’s probably true […] I’m never going to get into an argument with the market.”

Despite the ever-present chance of the market being wrong, three more hikes over the next year and a half is probably the best assumption one can currently make when choosing between a fixed and variable rate.

The market is betting that those rate hikes will happen approximately every six months. So, for our hypothetical purposes, one could assume quarter-point hikes in January, 2019; July, 2019; and January, 2020; before rates drift sideways for a while.

With those assumptions in hand, here’s how you’d make out in a standard $100,000 mortgage amortized over 25 years with competitive rates.

If your mortgage is insured (i.e., you have less than 20-per-cent equity):

A five-year variable at 2.6 per cent, or prime minus 1.1 per cent, would cost you about $25 more over five years than a five-year fixed at 3.19 per cent. (i.e., peanuts)

If your mortgage is uninsured (20-per-cent equity or more):

A five-year variable at 2.64 per cent, or prime minus 1.06 per cent, would save you about $1,025 more over five years than a five-year fixed at 3.44 per cent.

These results assume equal payments with no changes to your mortgage for five years.

If your mortgage is bigger than $100,000, simply multiply the above-interest savings accordingly. For example, a $300,000 mortgage would entail three times the interest savings you see above.