One of the most challenging tasks when shopping for a home loan is to choose between a fixed rate loan or a floating rate loan. Is fixed rate always better than floating rate, or vice versa? To answer this question, you have to form your opinion about how rates will behave in the next two to three years while your loan is locked up, and how that impacts your overall cost. Below, we discuss a few possible scenarios that you should consider and how to take advantage of each type of loans in these situations.
Fixed rate is better in a rising interest rate environment
When the interest rate is rising, fixed-rate loans can give you up to 10 per cent of cost savings by locking in the current (low) interest rate. According to our analysis of 2000-2017 historical interest rates, you could save as much as $16,641 by choosing fixed rate if you took out a loan of $400,000 in 2005, when the market rates began to rise steeply. These estimates are based on interest rate of 0.50 per cent plus the benchmark 6-month SOR, a 3-year fixed-rate period. We also assumed that the rate continues to rise to 5.00 per cent until 2022, after which the rate stays constant.
The result consistently held true for all three time periods, as long as they represented a rising interest rate environment. For instance, you would’ve save about $10,169 in interest cost compared to floating rate if you took a fixed-rate mortgage starting 2014, because interest rates have been steadily rising during 2014-2017.
Floating rate is better in a flat-to-declining interest rate environment
In a flat-to-declining interest rate environment, you can save up to 8 per cent of interest cost by choosing a floating interest rate, according to the same analysis as above. We can find a prominent example in year 2007, when the 6-month SOR peaked out at 3.52 per cent. As the interest rate kept declining, the floating rate adjusted each year to the lower market rate, but fixed-rate loans were locked in at these sky-high rates. As a result, you could’ve saved about $12,675 or 6 per cent of total interest cost if you took out a floating rate loan of $400,000 in 2007, compared to its fixed-rate counterpart.
It is also generally more advisable to get a floating rate loan in a flat interest rate environment. This is because banks typically charge you higher interest on fixed-rate loans in order to reflect the premium you are getting from knowing exactly how much to pay each month.
Because the fixed-rate period typically lasts for 3 years, almost all of your interest cost savings happen during that time. This means that if you took out a fixed-rate loan of $400,000 in 2005, over 86 per cent ($14,382 out of $16,641) of the savings would come in during the first three years, while the remaining 14 per cent happens over the remaining 27 years. This also represents about 38 per cent of interest cost reduction in the first three years. The ratios stay relatively constant regardless of which year the mortgage starts, meaning that the majority of your net position is determined in the first three years, unless you choose to refinance your mortgage.
Low interest rate also helps you pay down more debt
Not only does low interest rate reduce your cost in the first three years. In fact, it can also help you pay down relatively more principal each month, which in turn helps you pay less interest down the road. Let’s take a look at an example of how this would have worked in your favor in 2005, when the interest rate was rising. If you took out a $400,000 mortgage loan with fixed rate, over 50 per cent of your payment in the first 3 years would’ve been “principal repayment.” This is beneficial for you because principal repayment decreases your outstanding debt balance, which ultimately results in less interest costs. However, if you took the same loan with floating rate, only about 30 per cent of your payment in the second and third years (2006 and 2007, respectively) would go to pay down your debt.