I’ve always been transparent about my mortgage strategy. I prefer to select a deeply discounted variable rate (prime minus 0.80% or better), but if that’s not available then I’m happy to take a 1 or 2 year fixed rate mortgage and wait for those discounted variables to return.
We’ve been in our house for 11 years. Our first mortgage term was a 5-year variable rate at prime minus 0.80%. When that term came up for renewal the best variable rate discount was prime minus 0.25%. Not good enough, so I opted for a 2-year fixed rate of 2.19%. That term came up for renewal in 2018 and sure enough the variable rate discount had come back in a big way. I ended up with a 5-year variable rate at prime minus 1.15%.
Of course, variable rate holders were treated to an unexpected series of rate cuts when the Bank of Canada slashed its trendsetting overnight rate by 0.75% at the beginning of 2020. That dropped the interest rate on my mortgage to an absurdly low 1.45%.
Fast forward to 2022 and the Bank of Canada is widely expected to increase interest rates this year, starting as early as March. I’m not in the rate prediction game, but we’d be foolish not to at least expect the 0.75% emergency rate cuts from 2020 to be restored.
Meanwhile, my mortgage term doesn’t come up for renewal until September 2023. If I believe the headlines from economists and other forecasters, we may be in line for six to eight rate hikes before then. What’s a variable rate mortgage holder to do?
The Variable Rate Advantage
Variable rates borrowers typically save money versus five-year fixed rate borrowers. That was true from 1950 through to 2000, according to a famous 2001 study by finance professor Moshe Milevsky. He updated the study again in 2008, with a similar conclusion that “the probability of coming out ahead with a variable rate had increased to just over 90%.”
Fixed rate mortgage holders pay a premium for certainty in their payments. The less talked about disadvantage to a 5-year fixed rate term is that they can be terribly expensive to break if you sell your home or need to refinance in the middle of the term.
Variable rate mortgage holders save money because of the built-in discount. On a deeply discounted variable rate mortgage, rates would need to rise at least three or four times before it climbed above a fixed rate alternative. Furthermore, variable rate holders have the advantage of only being charged a three-month interest penalty for breaking their mortgage early.
The Variable Rate Dilemma
Now to the dilemma for variable rate mortgage holders like me. Nobody likes to lose money. Faced with the near certainty of rising rates in the coming months, it’s a lot like knowing the stock market is going to fall and trying to decide if you should sell or stay the course (Ed. note: We can’t actually predict the direction of the market so just stay the course).
My gut tells me to take the same approach as I would with my investments. Stay the course. But I wanted to get an outside opinion so I reached out to mortgage analyst Rob McLister and asked him:
“With everyone screaming “lock-in” is there any merit to doing so with just 18 months left on my mortgage term? And what exactly does locking in entail for a variable rate holder?
He said that variable-rate borrowers have four main options:
- Do nothing and ride out rising rates
- This may be the best play for someone with financial stability, a good variable discount (prime -1% or better), a modest mortgage relative to income and/or a short (e.g., <10 year) remaining amortization (Ed. note: We check all of these boxes).
- It’s particularly appropriate for those who may need to increase or break their mortgage before their existing term is up. Variable-rate prepayment penalties are often significantly less than fixed-rate penalties.
- Cancel their existing contract, pay (usually) a 3-month interest penalty, and get a new variable rate
- This can work for financially stable borrowers with a reasonable debt load who want to float their mortgage, but have an inadequate discount on their existing variable.
- The lowest nationally-available variable rate for qualified borrowers is now 1.39%. That’s prime -1.06%. This rate applies to all mortgage types, including refinances. Purchase, transfer or insured rates are 0.10% to 0.30% cheaper.
- Convert their variable to a fixed rate
- It would take at least seven rate hikes in the next 18 to 24 months for the lowest widely-available fixed rate to beat the best 5-year variable, based on interest cost alone. The market is currently pricing in six hikes this year (source: Refinitive Eikon OIS rates).
- If a 2% increase would stress your budget too much, and you’ve got an adjustable-rate mortgage (where the payments floats with prime), you may want to grab 3-, 4- or 5-year fixed while you can still lock-in one under 3%.
- If you do lock-in, minimize your penalty risk. Chose a “fair penalty” lender and/or make sure you won’t need to increase or break your mortgage before the term is up. Meaning, don’t take a 5-year fixed if you may need to refinance or sell (and not re-buy) next year.
- Break their mortgage (pay usually a 3-month interest penalty) and get a new fixed rate.
- Occasionally a lender’s fixed rates will be too high relative to the competition. In that case it’s often more economical to pay the three-month interest penalty and move to the lender with the best fixed-rate on the market.
There are naturally exceptions to the above, especially for less qualified borrowers, so personalized advice can help.
You can lock in simply by contacting your lender and completing simple paperwork, online or in person.
One last thing: Too many people make binary decisions on their rate. You don’t need to pick between fixed or variable, you can choose both. Hybrid mortgages let you allocate half of your balance to a fixed rate and half to a variable rate, or any other combination. That provides valuable rate diversification, given no one can predict the future, and guarantees you won’t be more than half wrong. You can find hybrids at 2.17% or less from lenders like HSBC or Scotia eHOME.
Final Thoughts
Thanks to Rob McLister for providing these options for variable rate mortgage holders like me who may be nervous about interest rates rising in the near future. For me, I think about the money I’ve saved for the past two years when rates were slashed by 0.75%. I accept (and expect) that those rate cuts will be restored very soon. What happens after that is anyone’s guess.
In the meantime I will hold onto our existing variable rate mortgage at prime minus 1.15%. I know that our mortgage payment won’t change when rates do rise – the payments are fixed – but less of the payment will go towards principal and more will go towards interest. That’s okay. I’ve already saved a bunch of money over the life of this 5-year term.
When this term comes up for renewal in September 2023, I’ll do what I’ve always done. Look for another heavily discounted variable rate mortgage or, if that’s not available, take a short-term (1 or 2 year) fixed rate term.
Investors should lower their expectations for future stock returns. I’ve been saying this for a while now, but it bears repeating again now that stocks have gotten off to such a rocky start this year.
Markets are largely efficient and tend to go up over the long term. But they can certainly overshoot expectations in the short term. Remember that Canadian and US stocks have returned an average of 8-10% over a very long period of time. But the actual annual returns have ranged between -47% and +47% (1929 – 2022).
Investors have short memories. A raging bull market feels like it can last forever and investors become overconfident with their risk tolerance.
Many conversations with readers and clients over the past two years have been about FOMO. Investors with a conservative to moderate appetite for risk suddenly hunger for higher returns and want to dial up their equity exposure or tilt it towards assets with strong recent performance (crypto, tech, clean energy, or simply more US stocks).
That’s understandable when Canadian and US stock markets soared 25% last year. But we can’t expect markets to rise by double digits every single year. Heck, we can’t expect a 60/40 balanced portfolio to deliver double-digit returns like it did in 2020 and 2021.
Indeed, that’s why we shouldn’t be surprised to see a sharp price correction like we’ve seen this past month to bring prices back in line with reasonable valuations and expectations. This is a feature of the stock market, not a bug.
But largely the same investors who were eager to dial up their risk to chase past returns have been even more vocal about January’s poor returns. They want to know why their portfolio isn’t working.
To be blunt, if you don’t know your risk tolerance the stock market will decide it for you.
Behavioural psychology has taught us that the fear of missing out on theoretical gains from holding a less risky portfolio will only feel half as bad as losing actual money when your riskier investments crash.
Worse than increasing the risk profile in your portfolio to chase higher returns would be to completely abandon ship and sell now that markets have fallen. Now you’re locking in those losses for good.
Zoom out. Take a breath. The broader Canadian market is down 2% on the year. That basically takes us back to November 30th price levels. How did you feel about your portfolio then? The S&P 500 is back to mid-October price levels. Again, were you in panic mode back then?
Balanced portfolio investors (represented by VBAL) have seen their holdings dip back to price levels not seen since early October. But if you zoom out one year, a balanced portfolio is up a respectable 3.95%, plus dividends. Zoom out two full years and it’s up nearly 11%, plus dividends.
Predict a Stock Market Crash
With that out of the way I want everyone to watch this excellent video by Preet Banerjee about predicting stock market crashes. You’ll see that the best investing strategy is to pick an asset mix that you can stick to for the long-term and ignore the short-term gyrations of the market.
More than just avoiding the worst mistake (selling everything and going to cash), a big lesson here is to resist the urge to do something based on current market conditions.
As PWL Capital’s Ben Felix says, “your investment strategy shouldn’t change based on market conditions.”
Now I want you to play the stock market timing game that Preet shared in the video and share your results in the comments. In my first attempt I sold out quickly after a 20% gain only to watch the market climb nearly 100% in the three-year period (early 1950s time period).
I’m sure you’ll find that a buy and hold strategy outperforms all but the luckiest market timers.
This Week’s Recap:
It has been a while since my last weekend reading update. I’ve since shared my net worth update for 2021. I also shared some tips on how to save more this year.
My retirement readiness checklist was a big hit. So was my recap of Vanguard’s 10-year anniversary in the Canadian ETF space.
This week I also busted a myth about working overtime with the next tax bracket myth.
I’m an emotionless robot when it comes to investing and so I stick with my simple one-ticket diversified portfolio (VEQT). But many investors adopt a core and explore approach to their investments and my latest MoneySense article offers some guidance on how to manage the riskier part of your portfolio.
Promo of the Week:
If you’re looking to change up your credit card rewards strategy (or start some light travel hacking) then our friends at Credit Card Genius have you covered with the best credit cards for 2022.
Once again the American Express Cobalt card tops the list of best overall credit card. My wife and I both use the Cobalt card for groceries and dining out.
What about your card – did it make the list?
Weekend Reading:
Economics professor Trevor Tombe offers a great explanation of what’s driving inflation in Canada. Worth a read for those who think the Bank of Canada simply needs to pull a lever to make this go away.
The Canadian Real Estate Association says its house price index was up 26% in 2021, the fastest pace on record.
Morgan Housel explains why it’s hard to distinguish what’s happening from what you think should be happening.
A terrific read on five investment lessons from the latest word craze – Wordle.
Millionaire Teacher Andrew Hallam shares a dumb investment mistake even smart people make:
“Unfortunately, buying last year’s top-performing funds is a bit like peeing in your own bathwater.”
Blair duQuesnay reminds us that we don’t get to choose when markets sell off.
John Robertson takes a deep dive into free investing apps and concludes, “Do not trade on your phone.”
Back to Preet Banerjee with another excellent video, this one examining the phenomenon of crypto FOMO. He looks at whether the early crypto returns can be repeated, and why you may already have exposure through the holdings in your index funds:
Here’s an interesting (and disturbing) look at what you learn from a year of watching bad financial advice on TikTok.
A Wealth of Common Sense blogger Ben Carlson shares his favourite investing performance chart for 2022 – the asset allocation quilt.
Should you invest a lump sum of mooney immediately or dollar cost average in over time? My Own Advisor Mark Seed shares the answer.
Jason Heath answers a reader question about whether you should apply for OAS if you have a high income.
Michael James on Money says now is a good time to decide whether your portfolio is too risky.
CPP benefits are indexed to inflation and that makes the case for deferring your CPP stronger than ever (subscribers).
Finally, remember the Beanie Baby crazy? Here’s what happens when the frenzy ends and the world doesn’t value your valuables.
Have a great weekend, everyone!
Let’s bust a myth about working overtime. Some employees incorrectly believe that when earnings from overtime, a bonus, or salary increase pushes them into another tax bracket they’ll actually take home less on their paycheque than before.
Some employees even refuse to work overtime because they believe they’ll pay more taxes and earn less money in the end.
I’m sure you’ve all heard of the next tax bracket myth.
Next Tax Bracket Myth
Here’s an example. An employee makes $50/hour and works 37.5 hours per week for 50 weeks per year. That works out to $93,750 per year before taxes.
Living in Alberta this employee pays $21,736 in taxes and takes home $72,014 after-tax for an average tax rate of 23.19% and a marginal tax rate of 30.50%.
The marginal tax rate is important because it’s the amount of tax paid on an additional dollar of income.
Here’s where the next tax bracket myth comes into play.
The employee is asked to work 20 hours per month of overtime and earn time-and-a-half for those hours – or $75 per hour. Over the course of a year the employee earns an additional $18,000, pushing their total salary earned to $111,750.
How does this affect the amount of taxes paid? Let’s take a look:
The employee now pays $27,851 in taxes for the year but takes home $83,899 – an increase of more than $11,800. The average tax rate is 24.92% while the marginal tax rate has jumped to 36%.
Problems with overtime earnings occur depending on how much tax the employer withholds at the source. This can work one of two ways:
- Source deductions are applied as if the employee remains at an average tax rate of 23.19%. The employee earned an additional $1,500 from overtime work but the employer only withheld $347.85 in taxes. This results in more money in the employee’s pocket every month; however there will be a tax-bill owing at tax time, resulting in an unhappy employee.
- Payroll can, however, withhold a greater amount of tax at the source in the case of a bonus or overtime earnings. For this example let’s say the employer withholds 36% of the overtime wages, or $540 per month in taxes.
In the second example, the employee is now upset because $1,500 in overtime earnings resulted in just $960 in additional take-home pay. Extrapolate these deductions over 12 months and the result is a fairly significant overpayment in taxes.
The good news is that the employee will get a refund at tax time.
Origin of the next tax bracket myth
My gut feeling is that the second scenario is more common and employees see more taxes deducted at the source when they work overtime or get a bonus.
Related: 5 myths about insurance
Some back-of-the-napkin math shows that the employee’s actual hourly rate for the overtime worked was just $48 (before the tax refund).
Employees might look at this and determine that picking up overtime is not worthwhile because they’ll earn less than their regular hourly rate after taxes. Enter the next tax bracket myth.
But this is simply not true. You can’t take the after-tax hourly rate and measure it against a pre-tax hourly rate. You have to compare apples-to-apples.
The employee’s regular hourly rate after taxes is $38.41. The actual overtime hourly rate is $48. Sure, it’s not exactly time-and-a-half. But the employee is clearly making more money working overtime regardless of the shift into the next tax bracket.
Final thoughts
Some people are confused about the difference between their average tax rate and marginal tax rate. Your average tax rate is simply the amount of tax paid divided by your income.
Related: 9 money myths experts wish you’d stop believing
Since Canada has a progressive tax system your average tax rate will always be lower than your marginal tax rate.
So just because a raise or another source of income bumps you into the next tax bracket doesn’t mean ALL of your income is now taxed at that rate.
Consider this myth busted.