Variable vs. fixed mortgage rates

Where does mortgage money come from?

The variable rate mortgage and the fixed rate mortgage are very different in terms of how they are funded. Fixed mortgages are bonds purchased by a mortgage lender, sold as a mortgage to a home buyer and then re-sold as a income based security back to the financial market.

Variable rate mortgage products are based on the prime lending rate. This is a fluctuating yard stick used by the Central Bank in Ottawa to determine borrowing rates on all loans in Canada.

It is impacted by the value of the dollar relative to other currencies and it regulates the amount of money that is being bought by the chartered banks from the federal reserve to service Canadian borrower's needs. The strength of the economy and the inflation rate determines the level the prime is held at when the Governors of the Bank of Canada meet every few months.

Due to the economic crisis in 2008, governments around the world, including Canada, have agreed to hold their prime lending rates low in order to keep borrowing costs attractive to consumers. This measure has been responsible for economic growth in all of the major industrial countries for the last five years and has helped stave off a deeper recession than what would have been experienced otherwise.

Like in all things however there is a consequence. The result of low rates in Canada has been positive for Canadian's purchasing real estate as it has extended affordability of housing drastically. Recent changes to the lending practices of Canadian lenders has been required so that the housing boom does not become a bust as values exceed a reasonable level.

These measures include reductions of amortizations, tightening of borrowing rules for self-employed, and requiring variable rate mortgage shoppers to qualify on a prescribed rate of 5.34 per cent.

Presently, mortgage rates are in the range of 2.6 per cent for a variable rate mortgage and 3.49 per cent for a five-year fixed rate. Before knowing which product to chose you must understand how they work.

Fixed-rate mortgages

Fixed mortgage rates are based on bond futures. They are a fixed contract where your payment does not increase for the duration of the term. You are "locked in" to a given rate and protected from rate fluctuations or increases. This is the mortgage most recommended for the following reasons;

-Clients are risk averse.

-They have bought a property at the high end of their affordability range.

-Clients are not knowledgeable about borrowing and are more advised to take something secure.

- You can maximize your borrowing capacity with a low five year fixed rate of 3.49 per cent, versus qualifying at a prescribed rate of 5.34 per cent.

Variable-rate mortgages

Variable rate mortgages, by definition, can change with market conditions at anytime. They are less expensive at this time as they represent today's cost of funds whereas fixed mortgages take a long term view with the understanding that rates will rise over time.

Variable rate mortgages are based on Bank of Canada prime less a discount. For example;

-Prime of 3 per cent less .40 per cent is a borrowing rate of 2.60 per cent.

-Variable rate mortgages have an early renewal feature which allows you to lock into than prevailing fixed terms at any time. It is a parachute into a fixed rate product should you feel the need.

-Variable rates are more risky as the opportunity and timing of the lock in is up to the customer. Long-term rates based on the bond market will leap up well in advance of a change in prime as professional financiers make decisions on bonds well in advance of newspapers following the story. For example, the recent run-up in fixed mortgages in June from a 2.89 per cent, five-year fixed mortgage to 3.59 per cent happened in a matter of weeks. People who had variable money then would have been well advised to lock in prior to the run up, but likely missed the opportunity.

-Variable rate borrowers must qualify based on a rate of 5.34 per cent due to recent rule changes. This may make a variable rate mortgage unattainable for many first time buyers.

Analysis

Variable-rate mortgages are a good product if you have owned before and can tolerate the risks of not locking into a fixed-rate mortgage, which are still at historic lows.

They are a good choice if you can afford a shock of a much higher variable rate later should you miss the opportunity to lock into a fixed mortgage at a timely moment.

Variable rate mortgages are less expensive but only relative to what is available in fixed term mortgages at closing. Pundits will advise that the variable rate is always a better choice although that is only true in the last five years as rates declined due to government intervention.

I believe the rate cycle is moving upward. As a historic perspective, the prime lending rate is typically in the 5 per cent range in a healthy economy. In the end, the decision to take a 2.60 per cent variable rate is a good one provided rates remain low for some time in order to save on interest costs, while not missing the golden opportunity to lock into rates in the 3.49 per cent range. When rates do trend upward, it will be a permanent move to rates in the 5 per cent range.