June 11, 2010, 6:38 am

Interest Rate Calculation – Mortgage Payment

by: The Financial Blogger    Category: Banks and You,Properties
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I don’t know about you but I am growing tired of the media telling us how high interest rates will become in a year or two. They keep writing in the papers about interest rate calculations affecting your mortgage payment if the prime rate goes up by 5%. Some of them even push the limit saying that the prime rate will be 7% within 5 years… how the hell would they know? Did they tell the world in 2003 that prime rate would it 2.25% for 18 months in 2008? Who was right back in 2003? Please, give at least one name!

So today, I’ll do something different. I’ll use the very same math to perform interest rate calculations that affect your mortgage payment, but on the other hand. Since the mass media always tend to show you how much you *might* pay if the prime rate goes up by 2% compared to a fixed rate, let’s take a look at how much you *paid* in excess since 2008 compared to a fixed rate.

So let’s take an easy example:

Mortgage; $200,000

Amortization: 300 months (5 years)

Negotiated 5 year Fixed rate: 3.85%

Negotiated Variable rate: P+0 = 2.25% for the first year, now at 2.50%

Before I start with my calculation, you can argue that you were been able to lock your 5 year rate at 3.69% or even lower, but I could argue back that some of my clients are paying way less than P+0, so let’s keep it this way.

So during the first year, you would pay $12,430.08 in mortgage payments if you had taken the 3.85%. With the variable rate of 2.25% during the first year, you would have paid $10,454.64… so 2K less for the first year.

Let’s assume that the prime rate will go up during the next 12 months with an average of 3% (which includes that it increases from 2.50% to 3.25%). Your mortgage payments will go up to $11,357.88 for the year. So you will be saving another 1K during this year.

So you start year 3 by paying 3K more in interest with your fixed rate or by applying the very same 3K on your mortgage to create a safety net. Let’s assume that you just took the 3K in your pocket and you keep the same strategy (either paying 3.85% fixed rate or 3.25% variable rate). And let’s imagine that the prime rate goes up to 4.50% (with an average rate of 4%). Your mortgage payment with this new interest rate increase would be $12,624.48.

So after 3 years, and a lot of interest rate increases, you have still saved a total of $2,853.32. So let’s push the interest rate higher to 5.5% with an average of 5%. Mortgage payments for the year totals $13,958.52.

So after year 4, your overall mortgage payment is still lower and you have still saved $1,324.88.

When we look at this scenario, you will be a loser if interest rate keeps increasing for 5 years in a row which is unlikely to happen. And if it does, you will have lost about $1,000 compared to the fixed rate. Then, if you keep with the variable rate for another 5 years instead of locking a very high 5 year term fixed rate (because if Prime = 5%, the 5 yr fixed rate could be around 7 to 8%). You are almost sure to see a decrease in interest rates during the next 5 years since we always go through economic cycles.

Final thoughts on interest rate calculations and mortgage payments

Based on these calculations, I am a firm believer in the variable rate but by simulating 5yr fixed rate mortgage payments. i.e. , you pay low interest rates (prime) but you make higher payment (simulate it a 4%). Therefore, you are building a huge safety net to compensate if the variable rate goes higher.

See, the future is not always black when we talk about variable rates ;-)

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Comments

by: 2Hirondelles | June 11th, 2010 (8:36 am)

When my ex and I bought our first house in ’91, we were paying 11. something%, and that was discounted. Folks spoke in awe of the 5 and 6% mortgages of the early 70′s such as our parents had had (and theirs had been locked in for the life of the mortgage!) and never did we dream that we would ever see those numbers again.

Yet, here they are. But just as they have come back, so could the double-digit mortgage rates. The problem with most folks sticking with the 5-year rate is that the money saved won’t go to the mortgage. It will go to a bigger car, or other luxury items, or paying down other higher-priced debt (not necessarily a bad thing, if it stays paid off, I guess)

The problem of course is that interest rates can go higher a lot quicker than that. I don’t think it will happen in the next 5 years (so I would agree with taking a variable rate right now), but I think in certain circumstances the risks are higher.

By the way, I see 3.39% for 5y fixed right now, so 45bps lower than your rate. Does that mean that we can also expect that getting Prime – 45bps is very possible right now?

The last time we had rates go down so much in Canada and then stay stable, they went back up very quickly.

In 1997, rates shot up from 4.75% to 7.5% in 1 year… a 2.75% increase.

What would your scenario look like if rates went up 3% in 2011?

Good post. Doing the math is a very important step.

Anyone with a mortgage needs to understand how mortgage interest is calculated and understand how savings today can have a big impact on your mortgage tomorrow. Even if you spend 2 years at variable, these 2 years early in a mortgage have a significant effect on the interest reduction and amortization over time. Did you ever notice that early in your term, the interest payment is higher than the principal?

The benefit of going with a variable does require, as you say, that you pick a payment higher than the minimum or similar to the fixed rate you would have picked. I strongly recommend that. That’s what I did last year.

Blend and extend between mortgage terms and rates is very powerful. You benefit from picking a new rate and term without breaking your mortgage. I personally have done that since I have never finished a term, I usually end up doing a blend and extend. It’s also why I pick shorter term since it makes it easier to accomplish that concept.

@BMSP,

if you look at the 1997-2002 period, you forgot to mention that the variable rate dropped by 3% between 2000 and 2002, that would also have to be taken in consideration, don’t you think?

At the very same time (in 1997), a 5 year fixed would have been negotiated around 6%.So 3 years out of 5 would have been under the 5yr fixed with a variable rate. I’m pretty sure you would be a winner.

And if you have taken your mortgage in 2000, you would have paid around 7% with a 5 years fixed, while the variable has stayed under the 5% mark during the whole time…

[...] Interest Rate Calculation – Mortgage Payment [...]

by: FrugalCanuck | June 11th, 2010 (1:27 pm)

Is this accurate? because your principle out of that yearly payment is going down. So by next year, you’re paying higher interest but on a smaller loan.

by: The Financial Blogger | June 11th, 2010 (4:35 pm)

@ Frugal Canuck,
You are right, the balance would be lower year after year. I didn’t go over the full calculation to keep it simple. The result would be the same though.

Thx for bringing this point!

TFB.

That’s exactly what I plan to do!

Variable, and then stimulate it by paying it off like a fixed rate.

Maybe the banks and the media collaborate together to try and scare people into picking fixed mortgages.

by: The Financial Blogger | June 12th, 2010 (9:10 pm)

@ Youngandthifty,

The answer is easier than this: what is the most interesting to say in the newspaper:

A) your mortgage rate will raise a little but everything should be fine if you have a good financial plan.

B) the end of the world is near, you will pay 8% on your mortgage in no time, you will lose your house, etc, etc, etc?

Sadly enough, the reality don’t sell, but fear is always a great seller :-D

If you can afford the risk, variable interest is always cheaper. The only time it isn’t is when you couldn’t stomach the chances of rates rising.

There was paradoxically a short time 2 years ago when fixed rates were briefly better than variable, but that is because the bank funds your fixed mortgage and your variable mortgage from different places.

Example I just checked: A 5 yr GIC right now pays 3.25% and a 5 yr mortgage is 4.5% A savings account pays around 1% and a variable rate mortgage costs 2.25%. The spread between both pairs are the same. The bank uses your deposits, whether GICs or bank accounts, to earn money through loans. Risk management means that they have to line up the cost of money with their revenues.

Bank can’t guarantee a 5 yr rate of 4.5% unless they have a money supply that allows them to make a profit: the 5 year GIC.

If they funded the 5 year mortgages from bank accounts and they suddenly lost deposits, or had to raise interest rates to keep them, then they would insolvent. They essentially give you a mortgage at 4.5% and sell it to someone else (many others actually) at 3.25%, keeping the 1.25% as profit.

Most bank branches have an ability to give up to 1.5% discount. I would assume than that their profit is possibly higher than the spread or they simply decide to cover it.

I use canequity.com which has a great graph that shows the 10 year historical prime rater versus the 5-year fixed rate. Variable is pretty much always better.

Even if mortgages rates go up to 6%, I do already pay a 6,23% with insurances included at Desjardins. We signed just a MONTH before the rates went down… talk about timing. And of course, because it was our first mortgage, they insisted a lot with a 5 years fixed rate.

It’s all about OUR interests… no? ;-)

Sorry, I am really in a bad mood when I think about this. I’ll never have another mortgage with Desjardins, and no 5 years fixed rate contract again, beleive me!

@Mama Zen
You could consider breaking it. The cost is usually 3 months of interest payment. You’ll need to read the fine print.

That’s what I did last year. I broke a 4-year term not long after I did a blend and extend to go variable. Paying the 3 months interest was worth it because the rate difference was so big that I save so much more than the interest.

Run the numbers. I use a spreadsheet with a mortgage calculator to compare the scenarios.

[...] -Under Promise, Over Deliver @ MoneySmartsBlog -Thinking about a fixed or variable rate mortgage? Here is a Canadian perspective @ TheFinancialBlogger -What if I could be Me at 20 again? @ [...]

@ CR,
Good explanation about how banks are calculating their profit. However, as the financial world advances, they use other type of financing than CD’s (this is why they offer to wave fees if you keep a specific amount in your bank account, liquidity counts as well!). They can use their own money, their own funding and other more complex financial products to offer funding for mortgages. But you will never see CD’s higher than mortgage rates for the same term ;-)

@ Mama Zen,
ask for your penalty calculation, you might end-up doing a good deal by breaking your mortgage.

@PassiveIncomeEarner: The profit is way way more than the 1.5% spread for 2 reasons:

1) The bank can lend more money than it has on deposit. Suppose it lends 10X, so the real profit is something like 4.5%*10 = 45% – 3.25% – the generous 1.5% discount = 40%+.

2) The money the bank lends is deposited into another account somewhere, so that will allow either their bank or another bank to make more loans.

This is where most of the money in the world comes from: Banks multiplying deposits. It’s created just by virtue of record keeping except the interest you pay is real and you have to work for it. That’s why them banks are so happy to give you a 1.5% discount, they still make 40% which is more than enough to buy huge downtown buildings made of marble and gold.

by: The Financial Blogger | June 17th, 2010 (6:29 am)

ahhh the magic of banks, it’s a shame that we can’t start a new one in Canada ;-) I’d be the first investor to jump in!