Variable vs. Fixed Mortgages
Mortgage Financing: Floating Your Way to Prosperity
Written By: Moshe A. Milevsky, Ph.D.
Associate Professor of Finance
Schulich School of Business
York University, Toronto
I provide detailed evidence that Canadian consumers are better off, on average, financing a mortgage with a short-term floating (prime) interest rate, compared to a long term fixed rate. This conclusion, on its own, is not original, since most financial commentators have argued this for quite a while. The contribution of this report is to rigorously quantify the benefit of the floating strategy by introducing and developing the concept of the Maturity Value of Savings (MVS) and the Total Months Saved (TMS). More specifically, I show that during the period 1950 to 2000, Canadians would have saved approximately $22,000 in interest payments — on a $100,000 mortgage amortized over 15 years — by borrowing at prime versus the five year rate. The probability of success from borrowing at prime, versus the 5-year rate, ranged from 75% to 90%.
In this report I examine the age-old question of whether to go ‘long’ or ‘short’ on a residential mortgage. When you take out a mortgage, you have the choice of borrowing at either a fixed or a floating interest rate. With a fixed rate mortgage, the payments made are based on a “fixed” interest rate and as a result remain constant over a predetermined length of time. If you decide to take out a floating rate mortgage, your payments are linked to a “floating” interest rate and are therefore likely to change frequently depending on the arrangement. In this case, I have tried to quantify the risks and benefits from taking out a floating rate mortgage based on the prime rate–and renewing the loan on an annual basis — compared to borrowing at the 5-year (fixed) mortgage rate. The main conclusion that was drawn from the analysis is that Canadian consumers are generally better off borrowing money at the short (prime) rate as opposed to the 5-year long rate – provided they can tolerate moderate fluctuations in monthly mortgage payments. The superiority of borrowing at the floating (prime) rate is a direct result of the fact that the term structure of interest rates (yield curve) is more likely to be upward sloping than downward sloping. Consumers (and all borrowers) pay for mortgage stability by incurring higher interest costs in the long run.
During the period 1950-2000, I estimate that a consumer with a $100,000 mortgage — that was to be repaid over the course of 15 years — would have spent an average of $22,000 more in financing costs by borrowing and then renewing at the 5-year rate, compared to borrowing at prime and renewing annually. Historically, 88% of the time, a consumer would have been better off borrowing at prime, compared to a fixed 5-year rate. Moreover, even in today’s relatively2 flat yield curve environment, I estimate that the forward-looking probability of success from borrowing at prime is approximately 65% and the average savings on a $100,000 mortgage is approximately $10,000.
The main message is quite simple. Long-term stability has its price! But, before we get into the technical details, let me review some basics about mortgages in Canada. A mortgage, of course, is essentially a loan. Like other loans, a mortgage represents a personal pledge by the borrower that it will be repaid. However, unlike other loans, the lender’s confidence that he or she will be repaid is not based solely on the investor’s overall personal financial health but also on the property that effectively underwrites the mortgage. If you (the home owner) fail to meet your mortgage payments, the lender has the right to “foreclose” on the property – that is, the lender can take title to your house, sell it off, and pocket the amount owed by you, the borrower.
The basic components of a mortgage are as follows:
- The principal. This is the total amount borrowed or currently outstanding on the mortgage. It represents the amount that you owe to the lender.
- The home equity. This is the value of the house above (or below) the outstanding principal of the mortgage. It represents the portion of the house that is yours. The equity is equal to the book value of the house minus the principal balance.
- The mortgage rate. This is the interest rate that you are being charged on the principal. Obviously, the greater the principal and the higher the interest rate, the larger your monthly mortgage payments will be.
- The mortgage payment: This is the regular installment of cash, paid monthly and sometimes even bi-monthly, with which you repay the mortgage.
- The amortization period: the number of years it will take to completely repay the mortgage if you make the above-mentioned mortgage payments until the outstanding loan has been paid in full.
- The mortgage term: the period of time covered by a specific mortgage agreement. When the term matures, the mortgage is renegotiated at prevailing interest rates. Hence, while the amortization period is typically on the order of 10 to 25 years, the mortgage term tends to be much shorter. It usually ranges from six months to five, or ten years at most. We say that a mortgage is ‘long’ if the term is closer to five years, and short when the term is closer to one year. However, THE most important thing to note about mortgages, and the essence of this report, is that mortgage interest rates (item 2) will depend on the term of the mortgage. In other words, if you pick a 5-year term, you might be charged 8% interest on the principal you are borrowing. While if you pick a 1-year term, you might be charged only 7% on the principal. The reason for the difference in rate, depending on term, is that the interest rate yield curve is not necessarily flat, but can be upward sloping or downward sloping depending on the period in question. Figures 1a,b, c provides sample yield curves for different points in Canadian history. More on this later.
- The prepayment options. Depending on the institution, the term and the type of mortgage, you might be granted the right to prepay a certain portion of the loan at fixed points in time — without incurring any penalties. This feature is related to the concept of open mortgage, versus a closed mortgage. One can always convert an open mortgage to a closed mortgage, but not vice versa. The mortgage payment, incidentally, is not simply the interest on the loan. It includes both interest and principal components. In other words, your mortgage payments are structured in advance so that instead of paying interest at regular intervals and repaying the original principal at the end of the mortgage, each periodic payment includes both an interest component and some principal repayment. The operating principle of a mortgage is quite simple. You initially receive a lump sum of cash, and then are obliged to repay it over time, in a series of blended payments including both principal and interest. If you fail to make these payments, foreclosure will take place. Then, the property will be sold, and your equity used to make a lump-sum payment, reducing if not eliminating the remaining balance owed on the loan.
In many mortgage agreements, of course, you have the right to pay down a portion of your principal. When and if you did so, you could then renegotiate (downward) the amount paid each month. Alternatively, you could keep the same total monthly payment, but finish paying off your mortgage much earlier than originally expected. In other words, with the reduction in the principal, you can change (in your favor) the ratio of principal and interest calculated into each payment. As more and more of your principal declined, more and more of each monthly or weekly payment would go toward principal.
The main question I would like to examine, once again, is what term you should select on your mortgage. Specifically, I would like to ask: “would consumers be better off if they picked a shorter term, like six months, or a longer term, like five years?” Recall that in a short-term mortgage, the interest rate can change each term, thus payments will change accordingly. In a long-term mortgage, the interest rate is fixed for the duration of the term, and therefore the payments are constant.
1. Dr. Bernie Wolf, Professor of Economics at the Schulich School of Business provided the macroeconomic commentary, and Dr. Chris Robinson, Associate Professor of Finance at the Schulich School of Business provided additional input and guidance. I would also like to acknowledge Mr. David Varadi for excellent research assistance, background work and editing of this report.
2. As of late January 2001, floating mortgage rates are in the 7.00% to 7.50% range, and 5-year rates are in the 7.25% to 7.75% range.
*CMHC (May 2005)