Fixed rates are now “superior,” said BMO in this report released Thursday.
“While we have in the past supported going variable,” circumstances now “favour…locking in…”
That’s been BMO’s rally cry since 2010 when it proclaimed “Time to Say Goodbye…to Variable.” In retrospect, that advice would have cost mortgagors handsomely. But BMO was far from alone in that call.
Few anticipated the economy would drag along the bottom, depressing rates for five years after the great recession. People are now becoming desensitized to statements like “We may not see such low fixed rates again any time soon” (BMO’s latest prognostication).
Sooner or later, economists will be right on fixed rates, partly for the reasons BMO mentions (including higher inflation). But there are things about BMO’s report that people need to know about.
BMO writes that “Historically, there has been little contest” with variable rates being the better play. It argues that 85% of the time since 1975, variable rates were more cost-effective.
Well, it helps that 1975 is the start date for BMO’s analysis. In the 30 years preceding 1975, prime rose 6.00 percentage points. Excluding pre-1975 data improves variable-rate performance in backtests. In the 30 years after 1975, prime rate fell 4.75 percentage points, helping variable rates win by default.
But more questionable is that BMO’s analysis uses posted rates. Posted rates haven’t been relevant for years. Mortgagors rarely pay them anymore.
York University professor Moshe Milevsky, the man who wrote the book on fixed vs. variable performance, found that when discounted rates were used, the frequency of variable-rate outperformance dropped by 13 percentage points (based on data from 1950 to 2007).
The spread between posted fixed rates and posted variable rates is currently 199 basis points. If you backtest that spread you’ll get markedly different results than if you use today’s actual difference of 65 basis points. Canadian Mortgage Trends’ research shows that, in this latter more realistic case, the frequency of variable-rate outperformance is not 85%. It’s 59%.
Studies based on spreads that no longer exist are inapplicable to today’s rate environment. Of course, applying today’s spreads to the 1970s and 1980s is also imperfect. The difference is that it’s much more realistic to assume that lenders could have offered bigger discounts in the past, than it is to assume posted rates will apply to the future.
Sure you can, but at what rate?
Today you can get a 5-year fixed rate of 2.99% or less. But people who lock in don’t typically receive those rates. Instead, they get their lender’s “conversion rate.”
For many big-bank customers, that conversion rate is the bank’s “special offer” rate. This is the rate often paid by people who don’t negotiate. It can be 50 basis points or more above rates on the street. Paying an extra half-point premium to lock in would cost an extra $4,700 in interest over five years on a $300,000 25-year mortgage.
And then there’s the “little” problem of rate timing. Many people give themselves far too much credit when it comes to timing interest rates. Some folks believe they can wait for the Bank of Canada to announce a rate hike, and then lock in, thus beating the jump in 5-year fixed rates. Unfortunately, by that point bond yields (which drive fixed rates) may have already risen by up to one-half per cent or more.
Coupled with the conversion rate premium, people with bad timing could pay upwards of one percentage point more than today’s best 5-year fixed rates when locking in.
Long story short, if you’re likely to lock in later, lock in now.
That’s what economists projected in 2009, 2010, 2011, 2012 and 2013…
In fact, the most objective and credible rate forecaster in the country, the Bank of Canada, has been wrong with its own forecasts for over four years.
Rate predictions are moving targets. Economists are paid to guess wrong. There are piles of research documenting how their forecasts are little better than coin flips most of the time. (More on that…) As a result, rate estimates deserve among the least weighting of all factors in mortgage-term analysis.
Some argue that the “best” mortgage strategy is picking the lowest possible rate, every time. That’s a horrible plan if the mortgages you pick have prepayment and refinance restrictions that cost you more than the rate savings. But assuming you chose reasonably flexible mortgages, this strategy would have served you well the majority of the time throughout history.
In the low-inflation and low-growth environment to come (read this report from Morgan Stanley), a short-term/variable-rate mortgage strategy should continue winning more often than not. But there will be cases when it doesn’t, and today may be one of them (albeit, we’ve heard that before).
In general, the cheaper it is to insure against higher rates, the more sense it makes for typical Canadians to be “insured.” The cost of laying off risk to your lender is the difference between long-term and short-term mortgage rates. Nowadays, that premium is roughly half of its historical average since 1970.
Put another way, it’ll cost you a heck of a lot less if you make the wrong rate choice today.
Relying on short- and medium-term economic forecasts are one of the least effective ways to choose a term. Using common sense yields far better results. That entails weighing criteria like:
1) Your finances
- See these I.D.E.A.S. for choosing fixed vs. variable.
- Stress test your mortgage to ensure you can afford higher rates.
2) Your 5-year plan
- Taking out equity, adding to your mortgage, or outright breaking the mortgage can get expensive if you pick a 5-year term with a harsh penalty or bad refinance policy.
3) Your ability to qualify
- Lenders assess whether you can afford a variable rate by projecting higher hypothetical payments using the Bank of Canada’s 5-year posted rate (4.99% today).
- By contrast, if you get a 5-year fixed you only have to prove you can afford that payment (based on a rate that’s roughly 2.00 percentage points below the posted rate).
4) The risk/reward
- Can you stomach a potential 25-35% jump in your interest costs? (Note: Some lenders keep your payment fixed but you’ll still pay more interest if prime rate rises.)
- Over the next five years, if the Bank of Canada lifts rates by even one percentage point and nothing else, a 5-year fixed mortgage costs less (based on interest cost alone, a mid-2015 hike and a mortgage with favourable prepayment and refinance conditions).
5) Economic factors
- While the least useful of all considerations, Canada’s position in the economic cycle should at least be contemplated.
- When variable rates have underperformed in the past, it has typically occurred after economic downturns.
- If we are indeed emerging from a trough in the business cycle, the next major move in rates should be up. In the last three rate cycles, the average prime rate increase from trough to peak has been 3.16%.
The preponderance of evidence suggests putting your faith in a variable-rate mortgage…over the long run. Those last four words are key because there are always exceptions, and those exceptions are more common than publicized studies suggest.
If prime rate were 1.50 percentage points higher and/or the fixed-variable spread were 1.50 (for example) instead of 0.65, variables might be a safer bet. But, as BMO implies, today’s fixed-rate premium is now low enough to back the underdog: the 5-year fixed.
Rob McLister, CMT (email)