The first question people often ask when deciding between a fixed and variable mortgage is: “Where do you see rates going?”
They assume we as mortgage planners know…and of course we don’t. No one does.
We can, and do, present a variety of possible rate scenarios based on:
- where we are in the rate cycle
- how rates have performed after past recessions
- and other available research.
But you never know for sure where the rate setters (the Bank of Canada and bond traders) will take the market.
Aside from reading the tea leaves on rates, the best thing a borrower can do is measure his/her ability to handle rising payments. To gauge that, we use a handy acronym called IDEAS.
IDEAS stands for Income, Debt, Equity, Assets,Sensitivity to Risk.
- Income -- Is the borrower’s income stable and reliable?
- Is there a low chance of income interruption? (You don’t want payments to soar if there’s a chance you’ll be out of a job for a while)
- Does the borrower earn enough to pay his/her variable-rate mortgage as if it were a 5-year fixed mortgage? (i.e., Can he/she afford to set his/her payments higher to offset the effect of rising rates?)
- Debt -- Does the client have a reasonable debt ratio?
- Is the person’s total debt ratio under 40% based on the posted 5-year fixed qualification rate (so that his/her budget isn’t crushed if prime rate jumps to 6.25% or more)?
- Can the borrower withstand 50% higher payments if rates rocketed up 4%?
- Equity -- Does the client have enough equity?
- Is the loan-to-value under 80-85% so the person could refinance if absolutely needed?
- Assets -- Does the client have enough assets?
- Preferably 6 months of living expenses (in liquid assets) to act as a payment buffer if needed.
- Does the person have a credit line as a backup source of liquidity?
- Sensitivity (to Risk) -- Can the client accept risk?
- If rates increase 2.50%, can he/she handle payments rising over 30%? What if rates jump 4%?
- Does he/she understand that a fixed rate will save him/her more money up to 23% of the time--according to popular research? (Fixed or Variable)
If most, or all, of the answers to the above are affirmative, a variable rate is something the homeowner can entertain.
After evaluating someone against the IDEAS measure, we then discuss (among other things):
- The probability they'll need to break their mortgage early or increase it before maturity (each of which could impact their total borrowing cost due to differences in fixed and variable penalties)
- Future interest rate scenarios, and how rising rates could impact payments and amortization time.
- The tools that variable rate holders can use to deal with payment risk, like “hold-the-payment” features (which don’t eliminate payment risk entirely) and hybrid mortgages.
- The pros and cons of relying on a rate conversion (i.e., locking in a variable rate)
- The cost comparison of variable versus fixed terms, based on future rate assumptions.
For most people, the decision between fixed and variable will either save them thousands or cost them thousands. The goal is to try and take as much of the gamble out of the equation as possible.