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:
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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