Fixed or Variable? How to protect your mortgage from higher interest rates.

Fixed or variable? It’s a simple little question with enormous ramifications.

On a $500,000 mortgage, each 1% interest rate increase means your ability to borrow is reduced by $50,000. And it’s looking likely that mortgage rates will rise maybe by one or two percent over the next few years, considering Canada’s lowest rates were here for the long time.

It doesn’t need to be that way. You can actually turn this pattern to your advantage with in-terest rate averaging. Interest rate averaging is the number one method used by multinational companies to manage their debt, although they call it ‘weighted average cost of capital’. Just because you’re not a major international business doesn’t mean you can’t get some of the same advantages when you manage your debt.

To put it in a nutshell:

» Don’t fix all of your mortgages.

» Don’t put on variable all of your mortgages.

» Split your mortgage up so you aren’t ever hit hard by interest rate changes.

What interest rate averaging will do?

Averaging out your interest rates protects you from jumps in rates. It breaks your debt down into more manageable chunks, and you only need to deal with one or two chunks in an ave-rage year. With Canada’s fast-changing economy and volatile interest rates, this system prevents your properties from being at the mercy of the Bank of Canada announcements.

If you leave yourself at the brink of your servicing maximum, a sudden increase in interest rates can force you into a quick sale – the last thing any investor or homeowner wants to do. A higher cost of debt can create uncertainty and panic, not just for you, but for the whole market. Plus, you don’t want to have fixed rate for 5 years at 5.89%, as so many people did in 2008, only to see rates fall to 3.59% by mid 2009. Even in 2013, I’ve met the odd person coming off a high five-year fixed rate from 2008; that person has probably paid at least $50,000 in additional interest on that mortgage. You really don’t want to be that guy, do you?

It is possible to pay a penalty to get out of your fixed term, and in competitive conditions banks will pay for the appraisal and legal costs, but avoiding this problem is much better than having to negotiate your way out of it.

I still meet people who don’t know that they can split their mortgage even once, let alone six times. Theoretically, you could split your mortgage into an almost unlimited number of chunks, but I recommend five as a maximum.

Here’s how to do it:

Your portfolio: One big house

Treat all your properties as if they are one big house. Let’s say you have five properties:

» Your own house, worth $850,000 and with a $400,000 mortgage,

» A house in Ajax, worth $450,000 and with a $300,000 mortgage,

» A townhouse in Brampton, worth $360,000 and with a $110,000 mortgage,

» A condo in Ottawa, worth $320,000 and with a $150,000 mortgage, and,

» Another house in Hamilton, worth $480,000 and with a $150,000 mortgage.

Instead of trying to split these up individually and work out how to average the interest rates, just put it all together. Your portfolio is:

Property worth $2,460,000, with a $1,110,000 mortgage

Split it five ways

In order to average out your interest rates, you want to have a split that looks something like this:

• 20% of your mortgage fixed for one year.

•  20% of your mortgage fixed for two years.

• 20% of your mortgage fixed for three years.

• 20% of your mortgage fixed for five years.

• 20% of your mortgage on 5-year variable.

This means that around $222,000 in debt needs to be allocated to each category. Rather than splitting each loan five ways, you can make it simpler. You can split it like this:

»»   Your own house: $400,000 mortgage, split into two chunks, one of $200,000, variable so you can pay in any additional income to reduce the mortgage, and one of $200,000 fixed for five years.

»»   House in Ajax: $300,000 mortgage, split into two chunks, one of $200,000 fixed for three years, and one of $100,000 fixed for two years.

»»   Townhouse in Brampton: $110,000 mortgage, split into two chunks, one of $55,000 fixed for two years and one of $55,000 fixed for one year.

»»   Condo in Ottawa: $150,000 mortgage, all fixed for two years.

»»   House in Hamilton: $150,000 mortgage, all fixed for one year.

Your totals are:

»»   $200,000 5-year variable.

»»   $200,000 fixed for five years.

»»   $200,000 fixed for three years.

»»   $305,000 fixed for two years.

»»   $205,000 fixed for one year.

Make a decision on each mortgage chunk when the fixed term expires

Each year, your one-year fixed amount of money will need to be renewed or refinanced, or you can decide to go variable for a while. In most years there will also be one or two more chunks that need to be renewed or refinanced. But interest rate averaging means you only need to decide what to do with an average of $222,000 in debt at any one point.

Budget for the higher fees

Interest rate averaging does multiply your paperwork and may require some legal or appraisal fees, however, they will be easily offset by the savings that result from eliminating the effects of rising interest rates on your servicing.

How much money can this save you?

It’s impossible to predict exactly how much you can save using interest rate averaging. But here’s an example on the total debt of $1,110,000 if the interest rate increases by 2% in one year.

January: Annual interest rate charges for 5-year variable at 2.75%: $29,957

December: Annual interest rate charges on total mortgage to 4.75%: $51,692

Increase of $21,735 in one year.

January: Annual interest rate charges on total mortgage amount split five ways with a variable rate of 2.75%

December: Annual interest rate charges on total mortgage split five ways with a variable rate of 4.75%

Increase of $3,916 in one year.

Using interest rate averaging saves you money across the term of your loans, reduces your uncertainty and makes your life easier.

You don’t even need to do much of the paperwork – just talk to your broker and we can make it as simple as possible.