Fixed or variable?

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   By Guest Blogger Ryan Lewenza

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All of us at Turner Investments ‘eat our own cooking’. We invest in the same balanced ETF models that are clients are invested in. We employ the same investment and tax strategies that we discuss on this blog and with clients. Essentially, we take all of our collective knowledge and experience in how we manage our own financial affairs and apply this to our clients.

To that end, we’ve recently been recommending to clients and readers to go with a variable rate mortgage rather than a fixed rate, which I recently did as well when renewing a mortgage on one of my investment properties. So today, I’m going to walk you through the steps and process on how I decided to go with the variable rate mortgage, and why we’re currently recommending our clients to do the same.

When making the call on fixed or variable you have to develop an outlook for interest rates. With this outlook you can then determine the average rate for a variable mortgage over the mortgage term and then compare that to current fixed rates. You then select the lowest one.

Let me explain the steps.

It’s abundantly clear that interest rates have peaked in Canada and that the Bank of Canada (BoC) will continue to cut rates in the coming months. It’s doing this because inflation has come down to its 2% inflation target (2.5% yoy as of August) and the Canadian economy has slowed. Stimulus is clearly needed through the lower interest rates.

With this week’s 25 bps cut, the Canadian overnight rate now sits at 4.25%. Looking at bond market expectations from Bloomberg, the BoC is expected to cut rates five more times over the next 12 months. The bond market is pricing in 25 bps cuts at the October and December meetings with three more in 2025. With the three cuts already and five more expected that would equate to eight 25 bps cuts or 2% in total. This just happens to be the average interest rate cuts (2%) that the BoC has done in previous cycles. I discussed this in a past blog.

With this information we can start doing some analysis.

In the table below I show the expected BoC interest rate cuts and the impact on the different interest rates. The Overnight Rate is our Canadian ‘benchmark’ rate that many loans are based on. We then add a spread to the overnight rate to determine the bank Prime Rate. With the Overnight Rate at 4.25% and Prime Rate at 6.45% this equates to a spread of 2.2% or 220 bps.

Lenders will then subtract a percentage off the Prime Rate to determine the borrower’s current variable rate. That spread can range from roughly 0.50% or 1% depending on the borrower and how aggressive the bank wants to be in getting the business. In my recent renewal I was offered -1% so that would equate to a current variable rate of 5.45%.

As seen in the table, if the BoC cuts rates as the bond market is calling for, my variable rate will drop to 5.2% in Oct, then 4.95% in December. By next June, my variable rate could drop down to 4.2%, if the BoC follows through with those five cuts. I then assume the BoC will keep rates unchanged for the next while as they assess the economic impact from these lower rates.

With the two years of data, I can then determine an average variable rate over the two-year period, which works out to 4.4%.

The final step is to compare that to current fixed rates. From Ratehub.com I see that the best 2-year rate is 5.88% from BMO and the best 3-year rate is 5% from TD. Now a good borrower can get a further discount off these posted rates, but even with a discount it’s going to be higher than the average 4.4% variable rate, based on my calculations. Given this analysis, I went with the variable rate when I renewed one of my mortgages.

So that’s the steps and process that I use in determining to go fixed or variable. Of course, there’s some assumptions here and it may not play out perfectly like this (e.g., inflation quickly comes back and the BoC reverses course) but based on my outlook for the Canadian economy, current bond market expectations and history, I think this is a pretty good estimate of what a variable rate mortgage will average over the next few years.

Finally, I told my mortgage broker that I plan to flip into a fixed rate mortgage sometime in 2025 (summer 2025?). The BoC cuts are expected to end mid-2025 so this could be the potential bottom in rates. As the Overnight Rate continues to decline, we should also see fixed mortgage rates decline, which are based on Government of Canada bond market yields. Maybe by next summer we could see 5-year fixed rates get back down to 4% and then I decide to flip back into a fixed rate.

For now, I’m personally going with and recommending to our clients to go variable as we’re still in the early days of this rate cutting cycle. If I’m right on all of this going variable is going to result in a lower average rate than current fixed rates, which will leave me with more Benjamins in my pocket to spend on a new guitar and some nice dinners out with my honey.

Market expectations for Canadian interest and variable mortgage rates

Source: Bloomberg, Turner Investments

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.

Source: https://www.greaterfool.ca/2024/09/07/fixed-or-variable/