Why I Won’t Sell Mortgage InsuranceJune 2, 2010
CMHC Loan Insurance – How It Works and How it Can Be ImprovedJune 22, 2010
We live in interesting times. While economists and pundits normally debate the degree to which an economic trend will wax or wane, we now have two entirely different schools of thought on where our economic momentum is headed. On the one hand, some experts believe that the US (and ultimately Canada, by close association) is headed towards deflation, where falling demand drives prices in a downward spiral, reducing investment and stifling economic activity. If they are right, interest rates will stay low for an extended period and variable-rate mortgages will be the best option by far. On the other hand, a different group of experts believe that we are headed towards a period of rapid inflation, which will be the inevitable result of governments continuing to print more money to ‘reflate’ the economy in an effort to spur economic growth. If they are right, interest rates will rise dramatically, and today’s fixed-rate mortgages will look like a once-in-a-lifetime bargain in hindsight.
With such vigorous debate among the experts, should you choose fixed or variable? The intrepid among us will hear the arguments and make a call. But for those of us who don’t want to risk the downside cost of being totally wrong for the upside savings of being totally right, I suggest the ‘safe mortgage’ approach. This involves a Hybrid mortgage product, often called a 50/50, that allows you to borrow half your mortgage at a variable rate and half your mortgage at a fixed rate. By blending your rate to equal parts fixed and variable, you are hedging against the risks of sustained deflation and/or runaway inflation.
Using today’s interest rates, a Hybrid mortgage would offer you a blended rate of approximately 3.15%. Every subsequent .25% increase in the prime rate will raise your blended rate by only .125%, while every decrease in the prime rate will lower your rate by the same degree. This partial hedge reduces your impact from a dramatic increase in fixed rates while still letting you derive some benefit from today’s low variable rates. For people who would otherwise lie awake at night worrying about whether they made the right call on fixed or variable, the safer Hybrid mortgage offers an attractive alternative.
For the record, I think deflation is our most pressing economic concern. I tend to agree with economists like David Rosenberg, whose deflationary view is based primarily on what is happening in the US. He worries that falling prices will lead customers to say, “Why buy today when tomorrow it will be cheaper?” A spiraling effect is then created where lower prices lead to decreased demand which reduces business investment which further slows economic activity and so on.
The most common rebuttal to the deflationary argument is that the US Federal Reserve (which plays the same role as our central bank) can just turn on its money-printing machines and flood the economy with more dollars. Fed Chairman Ben Bernanke made his willingness to use this approach known when he said, only half-jokingly, that he would drop cash on US consumers from helicopters if that is what it takes to create inflation. After all, if there is substantially more cash circulating in the economy with no change in the amount of goods and services, then rapid inflation should be inevitable. But ‘Helicopter Ben’ has had the printing presses going 24/7 for a while now and so far, this tactic hasn’t removed deflationary risk. That’s because the Fed, although important, is not the only influence on the economy, and US banks are not lending out the additional money that the Fed has made available. In fact, the US banking sector is contracting at a rate not seen since the 1930s.
If the American economy continues to struggle with deflation, runaway inflation in Canada seems unlikely in the interim. If we see a gradual increase in interest rates over time, then the variable rate will give you the lowest interest cost over the short and medium term. That said, most people agree that inflation is still a significant risk over the medium and long term, and nobody knows exactly when a transition from deflation to inflation will occur. If being exactly right on this issue is less important to you than not being completely wrong, consider my safe mortgage approach as a way to hedge against whatever economic weather is in store.