A friend of mine told me last week, “I don’t like reading your blogs when they’re about, like, numbers and taxes and stuff.  I like when you’re funny!”

Well, this might not be the blog for her…

I seldom offer an opinion on variable versus fixed because it’s like trying to explain to somebody why they should choose a blonde over a brunette, but perhaps an examination of the risks and rewards will shed some light on the decision…

My “blonde versus brunette” analogy wasn’t supposed to be a joke.  I’m serious.

That’s a personal choice that a person makes, based on tastes, opinions, and experience.

Maybe you like dark features, and the brunette also has dark brown eyes and he or she is more “exotic” to you.

Maybe you’re a fan of the classic blonde hair and blue eye combination.

Or maybe you like read-heads, who are completely nuts, which probably explains why I always chase them…

The variable versus fixed conundrum is one that is as hotly-debated as blonde versus brunette, and as in both cases, you’ll usually find there is a line drawn right down the middle.

The decision is one of risk tolerance, timing, and affordability.  Wait…..are we talking about mortgages yet? 🙂

The current variable rate is prime minus 75 basis points, or 2.25%.

The current fixed rate for a five-year mortgage is 3.49%.

Those 125 basis points might not sound like much when you consider how high mortgage rates have been historically, and I’m sure our parents would lecture us about how easy we have it and how either option is a steal.

And you know something?  They’re right.  Just don’t tell my Dad I said that, or he’ll add that to his list of “I told you so’s.”

Recent legislation to the mortgage market has forced brokers (and banks, if you choose to go that route…) to qualify borrowers as if they were using a five-year, fixed-rate mortgage regardless of the route that they choose.  This rule was intended to weed out some of the people who “shouldn’t” be in the market, and I commend the powers-that-be for putting this in place.

But whether you go variable or fixed, our parents are correct in reminding us that these rates are astonishingly low!  I told a client the other day that his 2.25% variable rate was “like free money” because it almost is, when you think about it.

So while I’m tempted to play Switzerland here and tell you that you can’t go wrong with either option, I will offer some insight into the upside and downside of each.

Let’s assume that my client, Brandon Marshall, is purchasing a $375,000 condominium with a 20% downpayment.

With a 3.49% five-year, fixed rate mortgage that is amortized over 35 years, his monthly mortgage payment is $1,234, of which approximately $866 is interest.

If he goes with a 2.25% variable rate mortgage, he’ll be paying $1,031 each month of which approximately $560 is interest.

The variable rate lowers his payment by $203 but lowers his interest cost by $306.

This matters to a lot of buyers, as many will look at their monthly interest cost before they look at their overall mortgage payment.  As I said – everybody is different, and has different criteria for evaluating the two options.

But here is where I stray off course a bit when I evaluate the two options: I never assume that you’re going to live at the property longer than five years.

Once again, it depends on who you are.  A 40-year-old couple with two children are likely buying a house to live in for 15-20 years, whereas a 26-year-old will probably move around a few more times before he or she settles down.

But when I advise my clients, many of whom are under 35-years-old, I tell them to make their assumptions based on a five-year time horizon.

Case in point, I have a client named Melissa who is looking for a condo at Vu, Rezen, or East Lofts.  She is debating the variable versus fixed options, and in fact, she was the inspiration for this blog post.

Without delving into her personal life too much, I told her, “Melissa, you’re 25-years-old and you have a serious boyfriend.  Chances are excellent that within the next five years, you sell your condo and move in with your boyfriend/fiancee, you two team up and purchase a bigger space, you get a job promotion or two and can afford to buy up, you’re relocated for work, etc.”

I told her to crunch her numbers assuming she’s in this property for five years, but don’t put all your stake into that.  Because of course, she could be there for longer, or she could take her mortgage with her if she buys another property.  You never know.

But that’s why we’re making assumptions.

So back to example with Brandon Marshall and his $375,000 condo.

The 125 basis point spread between the variable and fixed rate mortgages means he’ll be saving $3,750 in interest each year that he’s at the condo, assuming rates stay the same (which they likely won’t, but you get the idea).

From here, you start to make assumptions and predictions about the mortgage market and where it’s heading.

The question is: when do I lock into a fixed rate?

If you go with a variable rate and you stay at 2.25% for a year, you save $3,750.  At two years, you’re laughing with a $7,500 savings!

So if rates suddenly go up 50 basis points, and you decide to lock in to a 3.99%, five-year, fixed-rate mortgage, how does the new five-year rate affect you?

Well, in the 3.49% example, your monthly payment was $1,234 and you were paying approximately $866 in interest.

At 3.99%, you’re paying $1,321 per month of which approximately $989 per month is interest.

Over the next five years, you’ll pay $68,210 in interest.

Had you taken the 3.49% fixed-rate instead of going with the variable, you’d be paying $59,463 in interest over the next five years instead.

The $7,500 you saved by going variable at 2.25% for two years is LESS than the $8,747 increase in interest costs over the five-year term.

In this specific case – one that assumes two years at a variable rate of 2.25% followed by five years at a 3.99% fixed-rate, the variable rate isn’t worth it.

Of course, I did say that I always look at the “youngins” in a five-year perspective.

If we just looked at the total interest paid for three years at the fixed-rate, because our young Brandon Marshall had the variable-rate for two years, the interest would only increase from $30,493 to $34,900, or $4,407.  In this case, going variable followed by fixed would make for a savings of about $3,100.

You can analyze numbers all day long (and on Friday/Saturday nights like me…), but at the end of the day, it comes down to your risk tolerance and your comfort level.

Many buyers want security in knowing what their monthly payment is going to be every month for the next five years, or as long as they lock into a fixed-rate mortgage.  These buyers don’t want to follow the mortgage market, via the bond market, via the stock market, and have to always ask themselves or their significant others, “Is it time to lock into a fixed-rate mortgage?”

I’ve had clients on both sides of this fence.

One couple were in a variable-rate mortgage for the last four years before they sold their property, and they saved about $20,000 in the process.

But that’s hindsight, and hindsight doesn’t get you anywhere.

Mortgage rates can move overnight, but they generally don’t move that much.

If you’re in a 2.25% variable-rate mortgage and there’s a 3.49% fixed-rate sitting on the table, you’re not going to wake up and find that suddenly the fixed rates have moved to 5.99%.  They usually move in increments of 25 basis points, so I don’t think you can get burned that badly.

But if you’re in a variable-rate mortgage and you don’t pay attention for a year (which believe it or not, some mortgagees do), then you open the door to trouble.  And if you’re the kind of person who doesn’t pay attention to the mortgage market, then you should have sought the safety and comfort of a fixed-rate in the first place.

The one last consideration to make is with respect to the discharge penalty on a mortgage.

Typically, you pay three months interest when discharging a mortgage.  So it goes without saying that you’ll pay less to discharge your variable rate mortgage than you will to discharge your fixed-rate mortgage.  However, I can’t see this being a factor in any decision, since the difference will usually only amount to a few hundred dollars.

If you’re in my position, and you’re about to register a mortgage on an investment property that you’ll likely only hold until the condo is registered and you can get rid of it, then it makes more sense to go with a variable-rate mortgage.

In my example, over the course of one year, I’ll pay only $4,795 in interest as opposed to $7,433 (saving $2,638), and I’ll pay only $1,197 to discharge my mortgage instead of $1,854 (saving $657).  The 2.25% variable-rate over the 3.49% fixed-rate will save me almost $3,300 in a single year.

I think a one year time horizon is obviously the easiest place to make assumptions and feel “safe” with your decision.

But in any market, the only thing you can be certain about is uncertainty…