Rate Lock Considerations

People know that mortgage rates are at all-time lows.  What people don’t know is how long it will last.

There is going to be a time (perhaps sooner than some think) when bond yields run up and take fixed mortgage rates with them. This inevitably will be followed by throngs of homeowners rushing to lock in their mortgages.

Few can tell in advance when that time will come.  The only way most people can time the market is with hindsight—when it’s clear by looking at a chart that rates have bottomed.

If you wait until then, however, you’ll probably miss the lowest fixed rates by 1/4% to 1/2% or more.  So what do you do? 

Assuming you don’t have a discounted variable rate, like prime – 0.50% (those are keepers), one option is to take a good fixed-rate deal when you can get it.

People already in a variable or 1-year convertible mortgage can lock in at tremendous rates today. Typical conversion rates are roughly 3.95%-4.15% at the moment.  Compare that to posted fixed rates over the last 58 years (illustrated in this chart above).  4% is pretty darn good.  If bond yields bolt above 2.00%-2.15% (they closed at 1.97% Friday) no one can be faulted for locking in at today’s low rates.

There are also some amazing bargains out there for purchases, switches, and refinances.  One non-bank lender, Merix Financial, launched a new 5-year fixed promotion on Wednesday.  This mortgage has all the bells and whistles--20% prepayment options, portability, skip-a-payment, etc.--for a historically low rate of 3.69%.  That’s only 0.39% to 0.44% above most variable rates.  [This mortgage must close by May 29, 2009. No pre-approvals.]

No-frills fixed-rate mortgages--with only 5% pre-payment privileges--are also available at slightly better rates (but only in certain provinces).

Of course, if you’re shopping for a new mortgage you will come across alternatives to a 5-year fixed.  Some people are still advocating:

• Variable-rate mortgages (Variables have had a long-term statistical edge, but today’s environment is different. Most current variable-rate proponents are people trying to squeeze every last basis point out of the market. They tell you to lock in when the time is “right,” but they rarely tell you when that is.  If you’re going this route, good luck with both your timing and your rate conversion.)
• 1-year convertible/fixed mortgages (Same story as with variables.)
• 2-4 year fixed mortgages (While attractive last week, this week’s 3.69% 5-year option has reduced the allure of these terms--unless you plan to pay off your mortgage before five years, or plan to close after May 29.)

In general, the current alternatives are not overly compelling; however, exceptions do apply. Speak with a mortgage professional about your specific situation.

From a macro economic standpoint there are additional reasons to consider a long-term rate lock:

• The Bank of Canada’s overnight target rate is down to 0.50%.  That means there is very little room for bankers' acceptance rates and prime rate to fall further.  (Both influence variable mortgage rates.)
• Most economists expect that stimulus-led inflation will push up bond yields (and fixed mortgages rates) well before the economy actually recovers.
• Mortgage spreads have slowly been improving this year. As spreads get tighter lender margins often get smaller. This too may impede further fixed-rate declines.
• Bonds have become heavily overbought because investors have flocked to them for safety. If traders start to value return more than safety, bonds will fall and bond yields will rise.

Indeed, yields on the 5-year bond have been somewhat suspect as of late.  See the chart on the left (it shows 5-year yields over the last 12 months). Yields have been lingering quietly below the 2% mark for weeks now. They’re seemingly coiled like a spring--ready to leap higher at the first sign of economic strength.

Whatever the case, there is one simple question people should ask themselves:  “If bond yields run up from here, is it worth staying in a variable or 1-year mortgage?”

If economists are right, this gamble might save you 0.39% to 0.44% over today’s fixed rates for 6-12 months.  If they’re wrong (or you don’t time your rate lock properly), you could conceivably end up paying over 0.50% above today’s low rates…for the the following 4 to 4 1/2 years!

(Chart data courtesy of the Bank of Canada)

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Update (April 21, 2009):

The Bank of Canada announcement today will undoubtedly affect the rate-lock picture. Their unusual and very public commitment to keep rates low until June 2010 (contingent on inflation) may help depress bond yields further for the short-to-medium term. With yields now well under the key 2.00-2.15% area there is less urgency to consider locking in existing variable-rate mortgages--but keep an eye on that range.