As interest rates have risen over the past year, I’ve fielded quite a few questions from clients about whether they should opt for a fixed or a variable rate when they renew their mortgage.
On one hand, choosing a traditional five-year fixed mortgage offers the peace of mind that comes from knowing how much your monthly payment will be during those years. That security is especially valuable if rates rise as they have over the past year. Conversely, if rates come down, you may end up paying much more than if you’d gone with a variable rate.
While there’s no easy answer to this question, there is a wrong one. The wrong approach is to base your decision on a prediction about where interest rates are headed in the coming years.
It’s only natural to try to divine future rate movements. After all, we’re encouraged to do so by economists, analysts and other experts who offer up rate forecasts on a daily basis.
However, experience teaches us we can’t predict interest rates any more than we can predict the movements of the stock market.
You only have to think back to a couple of years ago when rates were falling to historically low levels. Back then, analysts warned at various points they couldn’t come down any further, only to watch as they hit one new low after another.
More recently, we were confidently told that rising inflation was a transitory phenomenon. But inflation turned out to be stickier than the experts thought and interest rates rose faster and higher than anyone had predicted in response.
I believe the deciding factor in whether to take a fixed or variable rate mortgage shouldn’t be based on a prediction about interest rates, but rather how much risk you’re willing and able to take.
The first question to ask yourself is: Can I afford the risk? If I opt for a variable mortgage and rates go up by 2% or more, will I still be able to make my monthly payments? If you can afford it, the second question should be: Which option will make me feel worse if I’m wrong – going variable and seeing rates rise or going fixed and seeing them drop?
Mortgage rates reflect what’s going on in the bond market and, currently, we are seeing the unusual situation where variable mortgage rates are higher than ones for a fixed five-year term. (A variable mortgage normally carries a lower rate to compensate borrowers for the risk that rates will rise.)
A higher rate for variable mortgages indicates the market expects interest rates to drop over the next few years. However, it’s important to note that rates would have to drop by more than what’s being currently charged for a fixed rate mortgage to make choosing a variable rate a winning strategy.
That’s because not only would the variable rate have to drop to the level of the fixed one but go below it to make up for the payments you’ve previously made at the higher rate.
So, if a variable is currently at 6.2% and a fixed is 5.5%[1], the variable rate would probably have to drop by double the current .7% difference between the two to break even over five years. In other words, you would be making a bet that rates are going to drop by 1.5 percentage points or more over the term of a five-year fixed mortgage if you opt for a variable rate.
While the bond markets provide important clues about where investors collectively expect rates to go, there are no guarantees that new developments won’t cause a rapid recalibration of this information and expert forecasts.
That’s why your focus when making this and other financial decisions should be on risk, not predictions.
[1] TD special mortgage rates as of January 23, 2023: https://www.td.com/ca/en/personal-banking/products/mortgages/mortgage-rates