Canadians risk averse when it comes to their mortgage, 86% take a fixed rate in 2009

The age old debate: should I take a variable rate mortgage or a fixed rate mortgage?

According to an article appearing in today’s Globe and Mail, most Canadians have an easy answer.

CAAMP, one of the leading organizations representing independent mortgage professionals in Canada, said that 86% of mortgages issued in 2009 (by CAAMP members I’m assuming) were fixed-rate mortgages. Variable rate mortgages appear to be maintaining a small market share despite record low interest rates.

According to the article, 70% of those who took a fixed rate opted for a term of 5 years or more.  I remember reading CMHC stats a few months back referring to 2006 figures. It reported that approximately 70% of fixed rate mortgages issued in Canada are 5-year terms. 7 and 10-year terms, on the other hand, are a small minority, as are the shorter maturities

It should come as no surprise that the market share for variable rate mortgages has not increased even with today’s very low rates. Most people who never had a variable mortgage and are not familiar with volatility of rates resetting every month in an environment of increasing interest rates managed to resist the hype (sic) about the attractiveness of variable rates while they are at an all-time low.

Historical studies, namely Professor Moshe Milevsky’s 2001 paper titled “Floating Your Way to Prosperity”, argues that floating the rate on a mortgage on a long term basis would pay it off faster than a fixed rate, saving the borrower money by reducing the amortization and interest costs. The inherent problem with variable rates is the volatility factor tied with the borrower’s current cash-flow. When interest rates increase over the short term, the borrower’s income more often than not stays the same. As such, to ensure that they would be able keep up with payments,the borrower’s present income must be subjected to a stress test by playing out a scenario where prime would increase to 5, 10, and even 15% respectively (we’ve seen prime at 16% in the 80s and there’s no reason to assume that we won’t ever see it again at that level).

While 15% prime is certainly an extreme case, it’s best to prepare the borrower for the worst. If the borrower’s income falls within the lender’s debt service ratios when we exacerbate the prime rate, then it can be assumed the borrower would fare off well against the volatility of a variable rate mortgage.

Assumption, however, doesn’t necessarily provide the full picture. We must also ask whether the borrower is fiscally responsible in handling their day-to-day finances as this plays a key factor in servicing future debt. For example, what is the borrower’s current debt habits? What happens if the borrower loses their income while rates increase (does the borrower have disability insurance)? Does the borrower have an emergency fund to sustain the increasing payment amounts (or make a lump-sum payment if their mortgage goes into negative amortization) if he or she lose or see a reduction of their income? What is the borrower’s present risk tolerance and what are his or her’s future goals? Do they plan on remaining in the same home for the duration of the term or do they plan on moving earlier (variable rate mortgages come mainly in 5-year terms while fixed rates mortgages provide a wider array of maturities)? Do they have any significant expenses that would have to be paid during the term (i.e. child’s tuition, placing a parent in a retirement home, etc.) which may affect their cash-flow to service increasing mortgage payments? While most variable rate mortgages can be converted into a fixed term mortgage at no cost, some lenders enforce conditions: a certain time period must lapse into the term and once converting to a fixed rate, the borrower must commit to a closed minimum term (which may or may not interfere with future plans).

All of these elements must be taken into account as part of the stress test to determine whether the borrower would benefit from a variable rate mortgage.

If we take CAAMP’s latest figures into account, it appears that the majority of Canadians are not ready to play Russian roulette with their mortgage and would rather pay the rate premium in exchange for predictability and easier time planning existing cash-flow.