Time to Re-consider the Variable-Rate Mortgage?

Variable-rate mortgage discounts aren’t what they used to be and for that reason, I have tended to favour fixed-rate options for some time now. Here, based on steadily accumulating economic data, is the case for the contrary view.

A good five-year variable-rate mortgage can now be found in the prime minus 0.40% range (which works out to 2.60% using today’s prime rate), compared to prime minus 0.75% or better in years past (which works out to 2.25% or lower using today’s prime rate).

At the same time that variable rates have been rising due to shrinking discounts, five-year fixed-mortgage rates have dropped to record low levels of 3.00% or less. Not surprisingly, with such a small gap between fixed and variable rates, just about anyone who has been in the market for a mortgage over the past year has chosen fixed.

But now that the best available one-year fixed rate has been increased, the five-year variable-rate mortgage is once again the cheapest way to borrow money in today’s market. And while variable rates can theoretically rise quickly, that seems increasingly unlikely in the current economic environment.

Those were the initial factors that got me scratching my contrarian itch. And the more I have thought it through, the more convinced I have become that the variable-rate option should no longer be dismissed out-of-hand.

First, consider these five reasons why I don’t think variable rates will materially increase any time soon:

• The bond market has an outstanding track record of correctly forecasting the direction of inflation and economic growth rates. At their current levels, bond yields are saying that inflation and growth will remain low far into the future.
• Many central banks around the world have their printing presses going around the clock and they have taken this extraordinary measure because they are worried about deflation, not inflation. To use the U.S. as an example, so far, despite the U.S. Fed’s concerted efforts, the new money that has flooded into the economy is simply not circulating and overall U.S. inflation has remained benign. This is because risk-averse lenders are reluctant to lend and over-leveraged borrowers don’t want to borrow. Neither trend appears likely to change any time soon.
• While commodity prices have been on a fairly steady upward climb in recent years the cost of discretionary items has been consistently falling. It stands to reason that if you have to spend more of your income on the basic items that you need for survival (like food and fuel), you will have less money available to spend on discretionary items that come from highly sensitive sectors of the economy that are important for job creation and economic growth.
• Despite unprecedented levels of stimulus from the U.S. federal government that have come at the cost of record debt and deficit levels, the U.S.economy is in the midst of its weakest economic recovery ever. Normally, an economy that is still struggling the way the U.S. economy is today would require more, not less, government stimulus. But the U.S. federal government has used up its dry powder and must now withdraw much of the existing stimulus, while also cutting additional spending and raising taxes. This will create a huge disinflationary headwind for the U.S. economy that the U.S. federal reserve is already doing everything in its power to counteract (with a 0% policy rate and every other kind of monetary stimulus it can get its hands on). There is no denying that U.S. monetary policy has a huge influence on Canadian monetary policy, whether Bank of Canada (BoC) Governor Mark Carney wants to admit it or not. The BoC simply cannot raise its overnight rate much beyond its current level while the U.S. fed maintains its ultra-loose monetary policy, as it is expected to do for years to come.
• Depsite my concerns about the U.S. economy, its prospects still look downright rosy compared to the EU’s economic outlook and more specifically, to the outlook for its seventeen member countries who share the euro as their common currency (otherwise known as the euro-zone). Deflation is a very real and present risk in the euro-zone and history shows a high correlation between European and U.S. economic activity. If there is deflation in Europe, it is only a matter of time before it washes up on American shores and then seeps north to ours.

Here are a couple of other points specific to variable-rate mortgages for you to consider:

• You don’t have to decide for yourself whether you can handle the risk of higher variable-rate mortgage payments because OSFI and the BoC now do that for you, with the BoC’s Mortgage Qualifying Rate (MQR) policy. It requires lenders to qualify each borrower using a payment that is based on the average posted rate at Canada’s largest six banks. Thus, if you want a variable-rate mortgage today, you have to show that you can afford for your payment to go from 2.60% to 5.24% (today’s MQR rate) over the next five years, which seems highly unlikely to me.
• Over the past 25 years in Canada, variable-mortgage rates have proven cheaper than fixed-mortgage rates roughly 90% of the time. There’s always a chance that now might be one of those rare, exceptional times when a fixed rate saves you money, but your taking one-in-ten odds that you’re right.

It is taken as gospel truth that inflation will increase when central banks engage in money printing and that rule should rightly give pause to informed borrowers who are considering a variable-rate mortgage. But we have never seen the kind of monetary intervention that we are witnessing today, especially when so many central bank policy rates are at 0% and on such a global, coordinated scale.

Simply put, although I believe that our central bankers will eventually create the inflation they crave,  I think the powerful countervailing economic forces listed above will significantly delay this outcome.

Five-year Government of Canada bond yields fell one basis point last week, closing at 1.29% on Friday. We are now back in how-low-can-you-go territory and five-year fixed-rate mortgages are once again widely available at sub-3.00% rates.

Variable-rate mortgage discounts can still be found in the prime minus 0.40% range (2.60% using today’s prime rate) and if you are the type of borrower who is more likely to lose sleep at night worrying that you are paying too much interest, instead of losing sleep worrying that your interest rate will rise, I now think this is an option well worth considering.

The bottom line: I think borrowers who are currently in the market for a new mortgage and who are comfortable with fluctuating payments will save money with a variable rate over the term of their mortgage (as long as it is five years or less). I also think that borrowers who already have a variable-rate mortgage (especially a deeply discounted one) should think twice before they convert to a fixed rate in today’s environment.

It would be easier, and less risky, for me to support the consensus view that variable-rate mortgages aren’t worth the risk but I think it is once again time to consider the variable alternative. This view, whether it turns out to be right or wrong, is based on what bond market yields and a mountain of economic data are telling me about a topic I monitor on a daily basis. Time will tell.