Mortgage risk and reward

Another mystery solved. I always wonder does it make sense to lock-in fixed rate mortgage if it is a lot more expensive than variable-rate mortgage. Lock-in is always worse off unless we are heading back to hyperinflation days in the 70’s.

By Deborah Yedlin, Calgary Herald May 16, 2010
Financial experts say variable-rate mortgages save money, but still half of all homeowners choose the lock-in option

As the Bank of Canada appears closer to moving away from the historically low rates that have been in place since financial markets melted down in 2008, the inevitable is upon Canadian consumers: interest rates are about to rise.

The question is when and by how much.

And if you happen to be in the market for a mortgage, the question of what to do — lock-in or float — looms large.

Of course, the big banks have already starting ratcheting up rates, with the Royal Bank of Canada and the TD Bank boosting rates well in advance of June 1 — the first opportunity in which the Bank of Canada could begin its tightening process.

For homebuyers, the difference in half a percentage point could very well mean being priced out of the market, if not a particular home.

For the sake of comparison — if a $300,000 mortgage floating at the current prime rate of 2.25 per cent works out to monthly payments of $1,300 — but at five per cent the monthly payment jumps to $1,750; that’s an extra $5,400 a year, and not exactly pocket change.

But before we go any further, it’s worth laying out an explanation as to how banks price their lending products and why commercial bank rates are so much higher relative to the benchmark set by the Bank of Canada.

In simple terms, the interest rate on a mortgage reflects what it costs the bank to borrow funds in the bond market, which they in turn lend to customers while also factoring in loan loss provisions and what they pay to depositors in interest.

In other words, there is much more to mortgage rates than where the Bank of Canada has set rates.

And in the case of mortgages, borrowers should also understand that what you see isn’t always what you get.

For example, the five-year closed rates at the Royal Bank might be set at 6.1 per cent, but after the all the fancy dancing and negotiating is done, the final rate is going to be somewhere between 4.5 and five per cent.

The reason rates go up as the term to maturity of a mortgage or bond increases is because the risk is higher the further out you are on the yield curve, because there is more uncertainty further out.

This suggests that by playing the short end of the curve, homebuyers can save substantial dollars



by opting for the floating rate.

“Traditionally . . . going back 30 or 40 years . . . the longer you’re in a variable rate mortgage, the further ahead you will be,” says Don Peard, vice-president, mortgage specialist for Alberta, with the Royal Bank of Canada.

But not everyone can afford to deal with the uncertainty of not knowing exactly what their monthly mortgage payment will be, even if it is at a lower rate.

“If I am a first-or second-time homebuyer and need to rely on both mine and my partner’s salaries, there’s comfort in knowing what my payment is every month,” says Peard.

But a study by York University Prof. Moshe Milevsky shows borrowers are better off if they choose the variable rate option — and by a huge margin.

Milevsky looked not just at what the savings are as a result of being charged a lower rate, he also assumed the difference between the fixed and variable payments was invested in 91 day treasury bills.

Using this methodology Milevsky concluded a borrower was better off 90 per cent of the time when they chose the variable option over locking-in at a fixed rate.

He debunked the notion that mortgage holders can come out ahead if they play the short-term end of the interest rate curve and lock-in at a certain interest rate.

“Even Canadians who can accurately predict the next move of the Bank of Canada, and lock in a mortgage just as the short rate is about to increase, are worse off on average compared with those who float over the entire interest rate cycle,” wrote Milevsky.

It has to be pointed out that under floating-rate mortgages, the monthly payments don’t change — what varies is the amount of the payment allocated to principal and interest. When interest rates drop, more of the monthly payment goes toward paying down the principal, while the reverse is true when rates go up.

Yet even though the variable option makes financial sense, Peard says about half the number of homebuyers go that route.

What’s interesting is that Peard says there are a number of unique characteristics in Alberta’s labour market — because of its tie to the energy sector — that support homeowners signing on for the variable-rate option.

These would be the compensation structure in the oilpatch — and investment industry, for that matter — which is characterized by bonus payments paid annually or semi-annually, stock options that vest over time or those that vest under a change in control of a company. In each of these cases, open-term, variable rate mortgages that allow for an unlimited amount of money being put toward the outstanding principal makes sense. By contrast, a fixed-rate mortgage allows for the paying down of principal to a maximum of 10 per cent, once a year.

The issue, as always, is risk tolerance.

In today’s world, whether it’s the Bank of Canada signalling it is going to raise rates beginning next month, or the attendant uncertainty permeating markets as a result of the sovereign debt issues unfolding in Europe, it all points to rates going up.

Yet even if the prime rate jumps 100 basis points (or one per cent) between now and the end of the year, that would put it at 3.25 per cent — still low by historical standards.

It might be true that the variable rate saves a mortgage holder money, but if they don’t have much equity in a home to begin with, are on a tight budget and therefore can’t afford to be vulnerable to interest rate spikes, the floating-rate mortgage isn’t necessarily the best option.

As Peard points out, many people have long memories and haven’t forgotten the fallout when interest rates skyrocketed in the early 1980s.

On the other hand, even if rates rise three percentage points through the next tightening cycle, the cost to finance a home remains far below what it was in the 1990s.

As in everything, there is an opportunity cost. In this case, it’s what could be done with the cash saved by opting for the floatingrate option.

And that’s what needs to be factored into the decision matrix when determining what to do with one’s mortgage — whether new or renewed.

Fixed vs. Variable

Fixed mortgages give borrowers:

– Certainty regarding the interest rate

– Certainty regarding the amount of regular payments

– The knowledge of how much of their payment is split between principal and interest

– A fixed amortization schedule

Variable-rate mortgages:

– Saves borrowers money

– Allows for lump sum payments on the underlying principal when possible

Source: RBC Royal Bank

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