Variable-Rate Mortgages: 3- or 5-Year?

November 16, 2009 

We’ve seen a noticeable increase in the number of people making variable-rate mortgage inquires. 

Perhaps it’s because the media keeps reiterating how the Bank of Canada won’t be upping rates until at least Q3 of next year.

Whatever the case, the popular options for closed variable-rate mortgages have been:

• 3-year variables near 2.15%
• 5-year variables near 2.10%

Which is the better?  The answer is not that obvious.

If variable-rate spreads remain the same, then whichever mortgage has the lower rate will entail the lowest cost (other things being equal).

However, if variable-rate spreads change in 3 years, it’s a different story.  (Note: we’re talking about the spread from prime changing, not prime itself).

For example, suppose variable rates improve from today’s prime – 0.10% to prime – 0.35% in three years.  In that case, the 3-year variable comes out ahead—even though its rate was initially higher.  On a $200,000 mortgage amortized over 25-years, the 3-year variable strategy would be roughly $409 cheaper than the 5-year variable. (We’re assuming prime remains constant for simplicity sake.)

Now the question becomes, is $409 worth the risk of not having your variable spread locked in for five years.  What risk you say?  Well, about a year ago, variable rates soared as high as prime + 1.50%. That was thanks to the market’s sudden aversion to mortgage lending.

While it’s no longer probable, it is indeed possible that variable rates could once again rise above prime rate.  If, for example, you assign a 1 in 4 chance of variable rates moving to prime + 0.25% or higher in 3 years, then the expected value of the 3-year variable makes it more expensive then the 5-year.

In sum, if you’re looking for a new variable-rate mortgage, you can boil it down to this.

Other things being equal:

•  
  • If you’re planning to lock your variable into a fixed rate within 3 years, go with the lowest possible variable rate mortgage–as long as it has a 4.25% (or less) fixed conversion rate, as of today.  [Mind you, if this is your plan, it’s worth talking to a mortgage professional about fixed-rate and hybrid mortgage alternatives.]
  • If you plan to let your variable rate ride, consider a 3-year as long as its rate is no worse than 0.10% above the 5-year.  The popular wisdom is that variable rate spreads will be better in 12-36 months.
  • Have your mortgage planner compare 1-year terms against the variable as well.