Thursday, November 11, 2010

Fixed or Variable? The perennial mortgage question

As a financial planner I have been asked this question over the past fifteen years far too many times to count. My basic and fundamental answer has never changed, regardless of what situation we find ourselves economically or on the interest rate yield curve.

History and statistics don’t lie: A variable rate mortgage or loan has proven to be the cheapest form of borrowing in nearly every 5-year cycle over the past 100 years.

I only deviate from this stance when a friend, a family member or anyone seeking advice expresses to me some form of concern for the “unknown” – the simple little fact that rates, especially variable – can change drastically without any given notice. Some folks just can’t stomach a variable rate today and not knowing what that rate might be 6 months let alone 5 years from now. And heck, can you blame them? At 3.75% on a 5-year mortgage why take the risk?

So the real answer: keep in mind history and statistical truths BUT follow your own risk tolerance and ‘sleepful night’ mindset. - Saverio Manzo

Another Prospective By Tom Bradley

Last week a friend asked me what his daughter should do with her mortgage. The bank was giving her the option of going with a variable rate mortgage at 2.5% or a 5-year fixed at 3.75%.

Investment professionals get asked this question all the time by friends and family. I’ve come to learn that the askers have way more interest in this topic than anything I could ever tell them about our funds or their portfolio. This is ‘food on the table’ stuff.

So how did this investment professional answer the question?

With regard to the lower variable rate, there is no free lunch here. Research reveals that going variable saves money over the long run (Note: 30 years of declining rates, since 1980, has a huge influence on the numbers), but it comes with the risk that monthly payments will go through the roof if rates rise significantly. A borrower should only go the variable route if she/he has the resources and stomach to absorb a big increase for an extended period of time.

As for the fixed rate mortgage, we have to keep in mind that 3.75% for 5 years is an UNBELIEVABLE rate. Yikes! Knowing you’re going to have low monthly interest payments until 2015 sounds pretty good. We shouldn’t forget that we’re living in an artificially low rate environment right now. It won’t always be like this.

As an investor, I’m always comparing reward versus risk. There is a good chance that a variable rate mortgage will win over the next 5 years, but the potential risk is substantial. It seems to me the borrower has a chance of winning small or losing big. Go fixed.

(Note: With regard to the numbers, I’m simplifying grossly here. Rates and conditions are different in each situation. And I’m told that variable mortgages are available at lower rates.)

About me: I give Economic, Social and Global trend briefings from some of the world's brightest minds at my blog and I also provide true and tested financial planning and wealth advice. Most recently, over the past few years, I have become socially conscious and have been attempting to practise ways in which I can live my life more environmentally friendly. Along with some truly exceptional friends, we provide consulting and business development for small-medium sized businesses. In addition, I truly believe in being philanthropic, giving and doing unto other as we would have them do unto us. Some of my fondest resources are from Barry Ritholtz of The Big Picture, David Rosenberg and what Warren Buffett of Berkshire Hathaway is up to behind the scenes, as an example.