With the news of rates rising, Cindy a client of ours came into our office the other day asking whether she should ‘lock in’ her variable rate to a fixed rate. Cindy has a 2.25% variable which is at .75% below prime (discounts are gone now). Her new fixed rate would be 3.39% for the next 5 years. She would also being going to ‘safety’.  It would however take a 1.14% increase in prime for Cindy’s rate to reach today’s fixed rate.  That is four to five one quarter per cent increases which could be one or two years away.  

For new mortgages the fixed rate appears to be the logical choice, and most people are choosing fixed because the spread between fixed and variable is so small, and it’s not worth the risk. Or so conventional thinking goes. Rates aren’t going any lower and in fact ‘gradual’ increases are now expected over the next year and beyond.  Any big increases are not in the cards due to fragile economic recovery in North America and even more perilous financial footing globally.

If rates have in fact started their ascent, then the decision to fix should be a slam dunk right? But hold on. What none of the experts ever factor in, is the prospect of a ‘penalty’. We asked Cindy if she expected to stay in her house for 5 more years, and she said ‘probably not’, and she told us she had to pay $18,000 to the bank for breaking my mortgage the last time she moved.

Folks that is a lot of interest.  Huge in fact. You see, the maximum penalty on a variable mortgage is 3 months interest whereas it is usually the ‘interest rate differential’ (IRD) with fixed rate mortgages.  We then told Cindy that if she sells within the next 5 years and a similar $18,000 penalty were to apply, the effective interest rate she would be paying becomes a whopping  5.169%.

No wonder why the banks always say go ‘fixed’ for new mortgages, and “lock in” to variable rate customers. They also know that Canadian households move on average every 3.5 years and that most people take 5 year terms. Funny that the so called ‘experts’ never include into the argument mention of the much greater penalty one must pay with a ‘fixed’ versus ‘variable’ rate mortgage.

There you have it. The ‘Secret’ is out. We would love to see a disclosure of how many hundreds of millions the banks must make on IRD’s every year.  Needless to say, Cindy is staying with the great variable mortgage we put her in.