Dave Larock in Monday Interest Rate Update, Mortgages and Finance, Home Buying, Toronto Real Estate News Editor's Note: Dave's Monday Morning Interest Rate Update appears on Move Smartly weekly. Check back weekly for analysis that is always ahead of the pack.
Last week two Bank of Montreal (BMO) economists, Douglas Porter and Benjamin Reitzes issued a report on mortgage rates arguing that “the fixed rate option now looks superior” to equivalent variable-rate alternatives.
I read this report with interest because I write about what’s happening with rates on a regular basis and my clients invariably ask for my take on the fixed versus variable debate at some point during their mortgage application process.
In today’s post I will examine the arguments that these economists used in reaching their conclusion, and offer my take on their findings:
Assumption #1: “The U.S. economy [is] poised to accelerate.”
The BMO economists’ main argument in favour of fixed rates centres around “the improving outlook for the North American economy”, and particularly the belief that “the U.S. economy [is] poised to accelerate.”
The consensus has certainly become much more bullish about the strength of the U.S. economic recovery of late, and we have started to see more encouraging economic data, but I have not yet come around to this evolving view for the following reasons:
- The U.S. economic recovery has been underpinned with massive quantitative easing (QE) programs which the U.S. Fed is now trying to withdraw. While the U.S.’s fragile economic momentum has survived the first two rounds of QE tapering, the real bite from the Fed’s withdrawal has not yet been felt. (I wrote about this coming challenge in detail in this recent post.) I think that the Fed will draw back their tapering if/when it causes U.S. bond yields to rise materially, and if that happens, the consensus estimates of the Fed’s tapering timetable will prove optimistic. Since the Fed has repeatedly said that it will not even think about raising rates until well after QE has been completely unwound, future hikes in U.S. short-term rates might not occur until well after mid-2015, as is widely predicted.
- The U.S. employment market is healing slowly but let’s not forget this is partly because the U.S. participation rate is near all-time lows and U.S. unemployment and disability payments are near record highs. Recent signs are encouraging but it will still be some time before overall U.S. employment growth meaningfully buoys middle class incomes. Since U.S. consumers account for about two-thirds of overall U.S. GDP, this has to happen before real, sustainable economic momentum can be achieved.
- The most recent uptick in U.S. economic momentum (Q4, 2013) has coincided with the largest increase in U.S. consumer credit since the third quarter of 2007. I would feel much more confident about an upswing in U.S. economic momentum that was fueled by rising incomes, rather than by increased borrowing rates.
- The impacts of the U.S. fiscal squeeze have not yet been fully felt and several of the experts I read think that last year’s federal budget cuts will continue to create headwinds for U.S. economic momentum well into the future.
- The U.S.’s rapidly aging baby-boom population will force its federal government to deal with the crippling cost of its entitlement programs while also addressing the rising threat of massively under-funded pension programs in the near future. These cans can’t be kicked down the road for much longer.
Interestingly, just about every prediction about rates heading higher over the last several years has started with the fundamental assumption that the U.S. economy was about to enter full blown recovery mode. So far that hasn’t happened, and those predictions have been proven wrong more than once. While Messrs. Porter and Reitzes may certainly end up being right about the U.S. economy achieving escape velocity in the near future, I remain sceptical for the reasons listed above.
Assumption #2: “The weakening Canadian dollar and upward risks to commodity prices from geopolitical uncertainty … could put pressure on prices to rise … [and] force the Bank of Canada to raise interest rates more aggressively.”
While geopolitical uncertainty could weaken the dollar, recent evidence suggests that the reverse might also occur. Over the past several years just about any type of rising uncertainty has increased demand for safe-haven assets, and Government of Canada (GoC) bonds consistently appear near the top of that shrinking list. We could therefore easily see foreign investment flood into the country in response to rising geopolitical tensions and that would drive the Loonie higher.
I also don’t subscribe to the thinking that higher commodity prices are likely to force the Bank of Canada (BoC) to raise rates.
First off, China is the world’s marginal buyer of most commodities and it is trying to move its economy away from the capital investment-led growth that it has relied on throughout its most recent economic boom period. It was the Chinese investment in capital goods that supported strong and growing commodity prices and the shift away from this form of investment is a long-term trend that should have much more impact on commodity prices in the coming years than the current tensions in Crimea.
Second, even if commodity prices do rise, the BoC has repeatedly told us that it will allow inflation to remain either above or below target for an extended period if circumstances warrant. If rising commodity prices caused by a geopolitical crisis push our inflation rates higher, raising our short-term rates would have no impact on the source of this inflationary pressure. So why would the BoC raise short-term rates and create the additional headwind of higher borrowing costs?
Anything is possible, but I think it is unlikely that events will unfold in this way.
Assumption #3: “Fixed rates are attractive because short-term rates are already at extreme lows.”
This is an oft-used refrain for the argument in favour of fixed rates. The thinking goes that if short-term rates are at all-time lows they can only go higher, so better to lock in a fixed-mortgage rate before that happens. But this is specious reasoning unless it accounts for the timing of when rates might rise.
For example, short-term rates reached extreme lows in Japan in late 1995 and are still there today. Anyone who chose a Japanese fixed-mortgage rate since then has paid more than they would have with a variable-mortgage rate, despite the fact that Japan’s short-term rates were at extreme lows throughout this period - just as the BoC’s overnight rate is now.
We don’t need the Japan-type deflation scenario, or even for the BoC to keep overnight rates at all-time lows indefinitely, for a variable-rate mortgage to win out over a fixed-rate mortgage over the next five years. As long as the variable rate stays low for the next twelve to eighteen months, it can rise fairly quickly after that and variable-rate borrowers will still come out ahead.
I ran a fixed versus variable rate scenario recently to illustrate how quickly five-year variable rates would have to rise before losing their advantage over five-year fixed rates. (The five year fixed rate I use is 3.35%, which is admittedly out of date, but so is the 3.49% rate the BMO economists used in their report.) Using the simulation, you can judge for yourself how realistic my forecast is and then gauge the likelihood that the BoC would raise its overnight rate even faster than my forecast assumes. For my part, I think my forecast errs on the aggressive side because we have record levels of consumer debt today which will exacerbate the economic impact of every BoC rate increase.
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 is 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.
David Larock is an independent mortgage planner and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear weekly on this blog (movesmartly.com) and on his own blog integratedmortgageplanners.com/blog). Email Dave
March 17, 2014Mortgage |