With Negative Interest Rates, All That Glisters Is Not GoldFebruary 22, 2016
Will Canadian Mortgage Rates Rise In Response To the Latest U.S. Employment Data?March 7, 2016
Let’s start with variable mortgage rates (VRMs), which are priced off of lender prime rates and typically move when the Bank of Canada (BoC) raises or lowers its overnight rate.
The BoC remains cautious about our economic outlook – who can blame them with oil prices hovering in the $30 range – and that makes it unlikely that the Bank will raise its overnight rate any time soon. In fact, BoC Governor Poloz recently acknowledged that the Bank almost dropped its overnight rate at its last policy meeting earlier this month, so the Bank’s current rate bias is clearly to the downside. And when we overlay our current low-growth, low-inflation domestic environment with today’s global bond market, where almost one third of the world’s government bonds are now trading at negative yields, it seems even less likely that the BoC will turn hawkish in the foreseeable future.
VRMs also offer more flexibility than their fixed-rate mortgage (FRM) equivalents because the penalty to break them is often much smaller. If you break a VRM mid-term, your penalty is typically limited to three months’ interest, whereas FRM penalties are calculated as the greater of three months’ interest or interest-rate differential (IRD). And IRD penalties can be huge, especially if you borrowed from a Big Six Bank. (If you currently have a fixed-rate mortgage with a major Canadian bank, I suggest that you sit down before clicking on that link that explains how different IRD penalties are calculated.)
VRMs have saved their clients a lot of money over the years, so if you choose this option, you’ve also got some compelling historical precedent on your side. There was a much-publicized study done by Dr. Moshe Milevsky, a Finance professor at York University, called Floating Your Way to Prosperity, which showed that the five-year variable rate saved Canadians money about 90% of the time between 1950 and 2000. The average variable-rate saving over fifteen years was a little more than $20,000 for every $100,000 borrowed, so we’re not talking about small potatoes here either.
At this point you may be wondering why there is any debate about fixed-versus-variable. After all, the BoC doesn’t appear likely to hike its overnight rate any time soon, VRMs offer more flexibility if you need to break them, and they have produced a significant saving for Canadian borrowers over an extended period. With all of those advantages, you may also be surprised to read that when borrowers ask for my opinion these days, I am not typically recommending VRM options as a first choice.
Five years is a long time, and while it doesn’t look as though variable rates are headed higher any time soon, circumstances can change more quickly than expected. Today you can secure a five-year fixed rate for around 2.50%, and five-year variable rates are offered at about 2.30%, so you’re not getting much of a discount for taking on variable-rate risk. The BoC typically raises its overnight rate by twenty-five basis points or more, which means that at today’s rates, the gap between the five-year fixed and variable rates doesn’t even cover one BoC policy-rate increase.
While it’s true that the BoC could choose to drop its overnight rate instead, its policy rate currently sits at 0.50% and the Bank would not be expected to drop to 0% unless emergency measures were called for. That means that today’s borrowers are looking at a maximum additional variable-rate discount of 0.25%, and even that is open to question. When the BoC dropped its overnight rate by 0.25% twice in 2015, lenders only dropped their prime rates by 0.15% each time. And when the BoC was expected to drop again at its most recent meeting, which it ultimately didn’t, there was widespread speculation that lenders weren’t going to pass on any additional rate discount. As such, I think it is safe to conclude that today’s variable rates do not offer much potential for additional saving.
While it’s true that variable rate penalties can often be lower than their fixed-rate penalty equivalents, at most lenders the IRD penalty only kicks in if your contract rate is materially higher than your lender’s rate that most closely matches the term remaining on your mortgage at your time of discharge. As such, fixed rates would have to fall further from today’s rock bottom levels for you to pay a penalty of more than three months’ interest if you decide to break your mortgage early, unless you opt for a fixed rate with a Big Six Bank, in which case you still get hosed (because their much higher posted rates in your IRD calculation, which I explain in detail in this post).
Lastly, while the oft-quoted study by Dr. Milevsky has produced some very compelling historical results, both fixed and variable rates fell for most of the period from 1950 to 2007, and in a falling rate environment, variable rates will always outperform their fixed-rate equivalents. Our five-year fixed rates probably don’t have much farther to fall over the next five years, with 2.50% as our starting point today, and that severely limits the usefulness of relying on past rate comparisons to predict whether variable rates will prove cheaper than fixed over the next five years (which Dr. Milevsky has readily acknowledged).
So although the fixed-versus-variable trade off looks like a no brainer in favour of the variable-rate option on first pass, upon closer examination I think the balance of probabilities today actually favours the five-year fixed rate for most borrowers. This conclusion isn’t based on a view of where rates may be headed in future, but is instead an assessment of the risks and rewards associated with both options. While you’ll pay a little more for a five-year fixed rate today, this ‘rate-insurance premium’ only costs you about 0.20% and that spread looks dirt cheap when using any historical comparison. In my view, if you can get cheap insurance against financial-market volatility in these uncertain times, I doubt that you’ll kick yourself later for taking it. Think of it in the same way that you think of the fire insurance you buy for your house – you hope you don’t need it, but if you do …
Five-year Government of Canada bond yields rose by eight basis points last week, closing at 0.68% on Friday. Five-year fixed-rate mortgages are available in the 2.44% to 2.64% range, depending on the terms and conditions that are important to you, and five-year fixed-rate pre-approvals are offered at rates as low as 2.79%.
Five-year variable-rate mortgages are available in the prime minus 0.40% to prime minus 0.30% range, which translates into rates of 2.30% to 2.40% using today’s prime rate of 2.70%.
The Bottom Line: The fixed versus variable question is essentially a risk/reward trade off. While variable rates have beaten fixed rates convincingly over the past 50+ years, I think that today’s variable-rate risks outweigh their potential rewards, and that’s why I am recommending fixed-rate options to most of my borrowers in the current environment.