Assumption #4: Low fixed rates “combined with a shorter 25-year amortization, would significantly strengthen a borrower’s financial stability.”
Really? I would argue that anyone taking a 25-year amortization when a longer amortization is available is weakening, not strengthening their potential for long-term financial stability, regardless of whether they choose a fixed or variable rate.
Remember that mortgages typically come with generous prepayment terms that allow you to reduce your effective amortization period with discretionary payments. This is far less restrictive over the long run than locking in a higher minimum payment by opting for a shorter amortization period – and less restriction means greater stability.
Put another way, why use a shorter amortization period and lock in a higher minimum payment that can’t be changed for the life of your mortgage term when you can take a longer amortization that offers more flexibility upfront and then reduce it by making discretionary payments instead? (Here is a post I wrote that outlines the benefits of this strategy, which I refer to as ‘cash flow buffering’.)
While it’s true that today’s low fixed rates give you a chance to pay off your mortgage principal more quickly, which will certainly help you improve your financial stability, today’s low variable rates offer an even greater opportunity to achieve the same objective. I regularly advise my variable-rate borrowers to set their mortgage payments at the amount they would be paying if they had chosen a fixed-rate mortgage instead. Doing this ensures that the interest-rate saving available with today’s variable rates is used to accelerate principal repayment, which is otherwise known as making hay while the sun shines.
As an added bonus, using this approach also gets my variable-rate borrowers used to paying more than the minimum required amount so that, if their rates rise in future, their discretionary payment can be reduced to neutralize the cash-flow impact of the first several BoC overnight rate increases. (I show an example of how this works in my rate simulation post, and in this post, which deals more generally about the power of making prepayments.)
Assumption #5: “Borrowers who don’t have much financial flexibility and would run into difficulty from a pronounced upswing in interest rates” are better off with fixed rates.
For several years now the federal government has required lenders to underwrite all variable-rate mortgage applications using the BoC’s mortgage-qualifying rate (MQR), which is currently set at 4.99%. That means that borrowers who want a variable rate at 2.40% today have to demonstrate that they can afford for their payments to more than double over the next five years, which seems unlikely based on any forecast that I have yet come across.
Messrs. Porter and Reitzes need not worry about borrowers who don’t have much financial flexibility running into difficulty if there is a pronounced upswing in interest rates because the MQR ensures that those borrowers are no longer able to qualify for a variable-rate mortgage in the first place.
Assumption #6: Fixed rates are a better bet because central bankers are becoming more upbeat on the growth outlook.
If you have read central bank commentary over the past several years you know that central bankers have consistently erred on the high side in just about all of their forecasts. In fact, central bankers have embraced such wide-eyed optimism in their growth forecasts since the start of the Great Recession that by all rights they should be forced to wear cheerleading uniforms and pom poms at their accompanying press conferences.
Instead of trying to predict the future, let’s quickly take stock of where we stand today:
- Canadian inflation rates are well contained and as the BMO economists point out in their report, we’ve been averaging just under 2% inflation for more than twenty years. That long-term trend makes it hard to envision the kind of inflation increase it would take to push the BoC’s overnight rate sharply higher in response.
- The Canadian economy is growing, but slowly. If the BoC raises its overnight rate, it knows that it won’t just affect consumers, it will also raise the cost of doing business and might stall our tepid recovery.
- The Canadian economy has a significant amount of unused capacity that would have to be absorbed over time, by our slow-growing economy no less, before capacity constraints would start to exert inflationary pressure on prices.
- The growth rate in household borrowing has slowed sharply and this has mitigated what former BoC Governor Carney called “the biggest threat to our domestic economy”. This reduces the likelihood that the BoC will raise rates to slow consumer borrowing, especially when the federal government has successfully used more restrictive lending regulations as a far more precise remedy.
- The timing of the first short-term rate increase in the U.S. appears to be at least a year away under even the most economically optimistic scenarios. (Reminder: Because U.S. and Canadian monetary policies are tightly linked, it is unlikely that the BoC would raise its overnight rate before the U.S. Fed raises its equivalent policy rate.)
My old boss used to say that the best indication of the weather tomorrow is the weather today. Simply put, my read of the weather today isn’t flashing many warning signs about higher variable rates coming any time soon.
One last point to add before we wrap up. When borrowers ask me whether they should go with a fixed or variable rate, I always ask them whether they are likely to lose sleep worrying that they are paying too much interest, or worrying that their mortgage rate will rise in future. The answer to that question often provides the best indicator of whether a fixed- or variable-rate mortgage is the way for them to go.
As for where rates may be headed, most borrowers normally base at least part of their fixed versus variable thinking on a subjective view of the future, human nature being what it is. Right or wrong, experienced mortgage planners who research interest rate trends on a regular basis can offer an educated view that helps inform a borrower’s thinking, both initially and throughout their mortgage term.
Besides, why should we let economists have all the fun?
Five-year Government of Canada (GoC) bond yields fell by ten basis points last week, closing at 1.61% on Friday. Market fixed rates have now fallen to the 3.04% to 2.99% range, and borrowers who are putting down less than 20% and who are paying for high-ratio mortgage insurance can even do a little better if they are comfortable with more limited terms and conditions.
Five-year variable-rate mortgages are offered at rates as low as prime minus 0.65%, which works out to 2.35% using today’s prime rate of 3.00%.
The Bottom Line: Over the past forty years, albeit in a generally declining rate environment, variable-rate mortgages have proven cheaper than fixed-rate mortgages approximately 85% of the time. If you’re going to argue that this time it’s different, you should really be able to make a compelling case. For the reasons listed above, I’m not convinced that Messrs. Porter and Reitzes do so in the report in question. If you can sleep comfortably at night knowing that your mortgage payments might rise in future, my read of the tea leaves still suggests that current variable rates can save you money over current fixed rates over the next five years.
This article first appeared on Dave Larock's blog.