Bucking the conventional wisdom on a fixed-rate mortgage

April 5, 2009


It is now widely-known that homeowners can save money by opting for a variable-rate mortgage over a fixed-rate mortgage in the vast majority of instances. Ben, an astute observer of financial matters, recently grappled with the question with his own mortgage and decided that with potential high inflation in the future and low spreads between fixed-rate and variable-rate, this might be one of those rare occasions when it makes sense to go fixed. According to Invis, a mortgage broker, fixed-rate mortgages can currently be had for 3.99% over 5 years compared to variable at 3.30% (Prime + 0.80%).

Should you go with a fixed-rate mortgage (FRM) or a variable-rate mortgage (VRM)? One thing is clear about questions of this nature: nothing is ever clear. In the same way that RRSP vs. mortgage vs. TFSA can never be answered definitively for all cases, the decision on whether to take a variable or fixed mortgage interest rate can also never be resolved in cookie-cutter fashion.

To paint broad strokes, banks charge a premium on FRM’s to accept the risk that money will not be so cheap in years to come – by accepting a VRM, and hence the risk, you stand to save money, historically, and on average.

Widely-reported Dr. Moshe Milevsky of York University authored a study in 2001, with a subsequent update summarized nicely here, where 90.1% of the time over 1950-2007 it was better to have chosen a VRM over a FRM (down to 77.1% if you have good negotiation skills and credit, and can secure a discounted rate). As discussed in the comments there, it would be nice to know what conditions existed in those minority of times when it was better to have a FRM, ie. historically, given that prime rate was x%, what was the probability that fixed would fare better than variable over the next finite time period?

Given that mortgage interest rates are currently at an all time low, one has to wonder whether historical studies have the same relevance when brought to bear on current market conditions. The spread between VRM and FRM is extremely slender at the moment – on a standard 5-year term closed mortgage, the best discounted VRM today is just north of 3% and the best discounted FRM is about 4%. The narrower this gap, the better one’s probability of doing better with a FRM.

Some have argued that when rates do begin to go up, as they almost certainly will in time, the increases will be modest at first and at that point early in the rise one can lock in to a fixed rate. However, it is a certainty that by the time the average Joe realizes it’s time to lock into a fixed rate, the banks will have raised the fixed rate higher than he could have gotten today. This becomes a case of pay less today on your VRM, pay more tomorrow on your FRM.

In a recent discussion, Dr. Milevsky states generally that people with a lot of assets and therefore increased ability to deal with risk should still consider a VRM. Dr. Milevsky offers that those with small home equity, or low or unstable income, may want to consider a FRM.

Historical studies aside, there are some elephants in the room these days. Job stability is at generational lows, house prices are in steady decline, the future of North American automakers hangs in the balance, and governments are pumping trillions into the financial system with uncertain results. These are uncharted waters.

Ultimately with mortgage rate choices, as with all other aspects of personal finance, it comes down to risk management. If we pull out all the stops in efforts to maximize the slice of pie at retirement, we run the risk of burning the pie, or finding we’ve arrived at the dinner table without a plate and fork. If we don’t take the occasional calculated risk, however, we may find that there’s not enough pie to eat on Tuesdays.

And as always, more important than the decision you make on VRM vs. FRM is the decision you make in your day-to-day life to control your expenses, increase your income, and direct the net savings toward paying off the mortgage and maximizing registered and non-registered investments.

[Update: You may want to check out this post on Canadian Mortgage Trends on the same topic.]

Smith Manoeuvre: Who Profits?

June 16, 2008


The siren song is irresistible: “Make your mortgage tax deductible” or “Want to beat the tax man?” — is that a trick question? Who doesn’t? This is also accompanied by a warning — “Don’t try this at home. This stuff is so complicated that you need our help to do it”.

While there is no question that the tax issues involved in implementing the Smith Manoeuvre are complicated and potentially require the services of a tax accountant to make sure that everything is set up right, it is worth asking if the warning isn’t a little self serving. If a homeowner simply builds equity in their home, no trailer fees or sales commissions are generated for the advisor. But, the home owner implementing the manoeuvre with actively managed funds, while compensating her advisor handsomely, faces long odds of making any profit.

How so? There is a striking consensus among pundits that future equity returns are going to be rather modest and real returns from stocks can be expected to be in the neighbourhood of 4% to 5%. We’ll split the difference and say that the risk premium — i.e. the extra return obtained when you invest in stocks instead of T-bills — is 4.5%. Let’s further assume that the real return on risk-free assets such as T-bills is going to be 0% (a very conservative assumption but we’ll give the Manoeuvre all the benefit it can get).

From the 4.5% excess return that stocks can be expected to provide, we’ll have to deduct the costs of the SM. First, there is the line of credit provided by our friendly bank at a 1.75% premium over the risk-free rate. That leaves us with a 2.5% premium of implementing the SM, which may not be too bad if a homeowner can handle the risk and negative behaviours that come with leveraged investing, especially when the portfolio grows to a significant size.

But, sadly, there is more. The average mutual fund in Canada has a MER of 2.5%. It is a good bet that the average mutual fund will produce, well, average gross returns. Net out the MER and the intrepid investor implementing the Smith Manoeuvre using an average mutual fund sold through an advisor will be left with a return of — drum roll, please — 0%.

It’s true that we haven’t accounted for the tax arbitrage between the deduction from income of interest paid and the capital gains tax rate on investment income. However, consider that (a) part of the investment income comes from dividends, which is taxed on an ongoing basis (b) mutual funds generate turnover that results in a tax bill and (c) capital gains tax is levied on the nominal, not real, gains. Does the tiny return justify the extra risk assumed in implementing the Smith Manoeuvre? I’d argue that there are less risky, old-fashioned alternatives such as simply paying down the mortgage.

So, who benefits from the Smith Manoeuvre? The bank made money on the loan. The advisor made money on commissions and trailers. The homeowner? Well, I suppose, as the old saw goes, two out of three ain’t so bad.