3-Year Fixed vs. 5-Year Fixed vs. 5-Year Variable

Article Summary: I would advise going with a 3-year fixed rate over the 5-year rate. I would also heavily explore the variable again while rates are as high as they are.

This is going to be really cool – I love graph and charts and tables. I’m looking forward to nerding out with you 🙂

3-Year Fixed vs. 5-Year Fixed
The first analysis we’re going to do is the 3-Year Fixed vs. 5 Year Fixed.
Rates as of now are (uninsured at 25 year amortization):
5-Year Fixed: 6.09% | 3-Year Fixed: 6.39%

On the face of it, the better rate is the 5-year fixed. You get a better rate (lower payments) and surety for 5 years. But, let’s do some simple math first, and then some more complex math later.
A 3-year rate would have 2 years left to compare against the 5-year rate.

Simple math:
-The 5 year is 0.30% better than the 3-years.
-There are 3 years of the 0.30% difference, meaning total variance is 0.90%.
-Two years at 0.90% yields 0.45%.

Therefore: the 2 year rate, or renewal rate after 3 years must be 0.45% better than the 5 year, or 5.64%.
Let’s do the math with a $500,000 mortgage and straight line interest.

So if we renew a 3-year rate into a 2-year+ mortgage at 5.64%, after a total of 5 years, we’ll be left with the same interest paid.
The key here is… do we think that rates will be lower 5.64% in 3 years?

My opinion is that we’ll end up at a more manageable rate level, far below 5.64%…

As an aside, I personally don’t think we’re going to get to sub-3% rates, I do think the new equilibrium is going to be in the high 3%s or low 4%s (read 1-3 years). I believe this because it is more inline with the average of the past 25 years.

So, go for a 5-year here? Naw – stick with the 3 year and renew when rates are lower.
Ok, let’s nerd out a bit and use amortization schedules…

The chart above states that the 3 year and 2 year combination would pay $1,490 more in total payments over the course of 5 years (0.77% variance in total payments), with $173 less in interest (0.34% variance).

Long story short, our simple math worked – cool story!
I actually smiled a lot when doing this example 🙂

And yes, the same math works for the 2-year Fixed vs 5-Year Fixed.

3-Year Fixed AND 5-Year Fixed Vs. 5-Year Variable
This example is slightly (wayyyy) harder to do because it requires us to guess what interest rates are going to be, and how they change, over the next 3 and 5 years.
Rates as of now are (uninsured at 25 year amortization):
Fixed: 5-Year 6.09%, 3-Year 6.39% | 5-Year Variable 6.30%

I propose to look at this in two ways: the 1st Scenario being a quick uptick in the variable rate so that our mortgage actually starts off at 6.55% (assuming 0.25% increase on October 25, 2023), and then a slow and gradual decrease of rates over the course of 3 and 5 years.

*Please note, my calculator assumes changes in interest rate every 6 months. The Bank of Canada has rate announcements 8 times per year (at non-conforming intervals); it is extremely difficult to build a calculator based on this timeline so my 6-month changes are approximations… heck, we’re (making educated) guessing here anyways, right?

For the 2nd Scenario, I’m going to assume no increase in rates and a decrease in rates by the 12 month mark, with a gradual decrease of rates after that.

Scenario 1A: 5-Year Fixed vs 5-Year Variable

With the above numbers, we’re expecting rates to increase right away (as per what we stated above) but then decrease after 12 months, 18 month, 24 months, and 30 months by 0.25%, 0.a25%, 0.5% and 0.5% respectively.
In this example, we come out ahead by paying $8,902 less in interest and $6,054 less in total payments.

Scenario 1B: 3-Year Fixed vs 5-Year Variable

With the above numbers, it’s surprising, we’re still ahead even though there has been less time with lower rates. The reason for this is the higher 3-year fixed vs the 5-year.
A start of 6.55% with a slow decrease of 1.5% over a 3 year timeframe provides for lower overall interest costs over 3 years.

Scenario 2A: 5-Year Fixed vs 5-Year Variable
This assumes starting point of 6.30% and a decrease after 1 year, with a gradual decrease of rates to 4%.

A decrease of rates from 6.30% today to 4.05% in 4 years would provide for a $23K savings over a 5 year fixed rate.

I find the above example to be more in line with my expectations. Or, if someone wanted to, they could go 50/50 with Scenario 2 and Scenario 1 for caution’s sake… Still ahead with the variable in both cases.
When the BoC increased their prime lending rate from 0.25% to 5%, the increase was 2000% in the span of less than a year and a half. These increases were and are emergency measures to combat inflation. Inflation is decreasing and rates will be cut; it’s a matter of when and not if (I believe)
*I think it’s important to note that anything can happen. Rates can continue to stay high and the economy *could* weather higher rates for much longer. Anything is possible. No one expected covid, the Ukraine War or what’s currently happening in the Middle East. You can and should still stay fixed if surety is what you need.

Anecdotally, the majority of our clients are still taking fixed rates! Each person’s situation is unique and the advice on whether to take a certain fixed term or even a variable would be unique to that person. Please do not take the above generalized advice as a catch all. Thank you 🙂

Scenario 2B: 3-Year Fixed vs 5-Year Variable

*Payments are so similar due to compounding. Variable rates generally compound monthly vs semi-annually.

The above table shows that even though we have less time, we’re still saving about $8,000 in interest. For this reason, I would pick the variable rate over the 3-year fixed.

Fixed Vs Variable Conclusion
When rates are as high as they are, it makes sense to look at the variable. The numbers work.

The problem I see is that we (many of my clients and I personally) got burned with the variable. The variable was SO attractive at rates hovering just above 1% and then bang… inflation and we’re now at stupid high rates when we could have locked in to a rate under 3%. It stung and it stings… I feel a lot of your pain if you chose the variable rate in 2021 and 2022.
But, for those of you who are choosing between the fixed and variable now, I personally would choose the variable rate again.

IF you believe that rates will decrease, the variable doesn’t just have better financials, it also has a few tricks up it’s sleeve.

Variable Mortgages Have Benefits
You can lock a variable in to a fixed rate at any time without a penalty.
Variable rates have 3-month interest penalties, which can be 1/4 or less that of a fixed rate penalty.
Some variable mortgages have static payments which allow faster payoffs and decreased amortizations when rates decrease.
Some variable mortgages have variable payments which will allow for payment relief when rates decrease – this is a big one. Some variable rates are open after 3 years (no penalty)And more…

Long story short – and this WAS a long story, I think it’s time to look at the variable again. I know I would…
Thank you for reading! If you enjoyed it or took something from it, please don’t hesitate to drop me a line below.

Email Eitan

3-Year Fixed vs. 5-Year Fixed vs. 5-Year Variable

The First Home Savings Account (FHSA)

Economic Update - October 25th, 2023

Continue Reading:

The First Home Savings Account (FHSA)

Economic Update - October 25th, 2023