68% of Canadians choose fixed-rate mortgages. Yet, most people would consider a variable-rate mortgage…if it weren’t for the darned payment risk.

RBC feels it has an ideal solution. It’s called the RateCapper mortgage.

“RateCapper gives homeowners the best of both worlds,” says Marcia Moffat, VP, home equity financing. “They can take advantage of a low prime rate, while at the same time locking in a guarantee they will never pay more than the ‘capped rate’ over the term of the mortgage, no matter how much the prime rate may rise.”

That “capped rate” is 5.85% at the moment. However, RateCapper borrowers start off by paying just 2.25%. Therefore, 3.60% is the most their rate can go up.

RBC has offered the RateCapper before. It originally launched way back in 1993. Moffat says it came out of hibernation because RBC has “seen increased demand for mortgage options that provide additional rate protection.”

RBC executive, Anjel Van Damme, told FP’s Garry Marr today: “It’s the best product in a rising-rate environment for consumers who can’t choose between fixed and variable.” (FP Story)

Claims like these always pique our interest, so we ran a few numbers.

First off, it’s worth noting that prime rate has averaged 4.81% over the last 10 years, and 5.85% since 1991. 1991 is when the Bank of Canada started inflation targeting and knocking down long-term interest rates.

If you assume that prime will jump back to its 1991-2010 average (not our prediction, just an assumption), it would take a 3.60 percentage point jump to get there from today’s rate.

So let’s assume prime goes up even more than that: four full percentage points.

That would take prime rate from 2.25% today to 6.25% by July 2012.

In that case, a regular prime – .50% variable would *still* be cheaper over five years than the RateCapper, by over $1,300 per $100,000 of mortgage.

Keep in mind, a 4% hike is well above the forecasts of most economists. If you *really* believe rates could go that high, a long-term fixed rate is a better bet. Given the same 4% rate hike assumption, a 4.35% five-year fixed–for example–would save you over $3,700 per $100,000 of mortgage, compared to the RateCapper.

If you want yet another alternative, consider a hybrid mortgage. Hybrids are part fixed rate and part variable rate. They’re meant to diversify your interest rate exposure—meaning they give you a chance to save interest while covering part of your backside.

As for the RateCapper, it’s a great idea at first glance. But in our view, RBC has set it’s 5.85% cap too high to be mathematically compelling.

____________________________________________________

**More on the above analysis…**

All scenarios above are hypothetical and approximate and assume a 25-year amortization, a 5-year term, and a 1/4 point rate increase at each BoC meeting starting this July (until rates rise 4%).

In reality, the BoC will likely pause its rate hikes at some point, and/or occasionally hike in increments other than 1/4 point. Nonetheless, a linear 1/4-point-per-meeting rate hike assumption is reasonable for modeling purposes and doesn’t invalidate the conclusions.

heh, I love how RBC thinks we’re incapable of math. Hilarious. Good for you.

I was actually thinking the rate capper sounded kind of good until I read this. LOL

m

A lot of people ARE incapable of math and of course it sounds good at first glance. It’s all about marketing.

great review like always, Rob. I share many of the same sentiments regarding this RBC product and the cap being far too high at this time to be compelling in the marketplace.

The bottom line is if a client has concerns regarding interest rate escalation and is not in a secure position to assume all the risks, they should not be in a variable product, period!

Great post.

Especially the part about a hybrid mortgage: a much better overall way to manage rising rate risk. I don’t understand why this isn’t the standard choice?

Good point about standard choices. However, my view of Hybrid and rate cap mortgages is the same as my view on all season tires. All season tires should be called “No season tires” because they do not perform well in any season. A Hybrid mortgage will never out perform a variable when rates trend downward or a fixed when rates are trending upward.

Umm…that’s the whole point of a hybrid isn’t it??? It’s called diversification. It’s intent is to forgoe a chance at doing better on one side or the other by diversifying the risk associated with such a bet. You won’t do as well as you would have had you made the right bet, but you won’t do as badly as you would have if you were wrong.

The problem is, how do you know what “tires” to get if you don’t know whether it’s going to be 30 degrees C or snow like a blizzard?

Unlike tires, you can’t change your mortgage twice a year so an “all-season” hybrid may be the way to go!

those darn Banks.

Always trying to make a profit by lending people money!

If you can’t sleep at night go fixed.

If you can, go closed variable and gain the best discount you can negotiate.

As opposed to getting the best of both fixed and variable I would suggest that you would be getting the worst and simply preying on the anxiety of the cautious mortgage shopper.

You can see why RBC does not use Mortgage Brokers. They sure would not want their costumers to get advice which might not be in the best interest of the RBC.

J. Woods, AMP

Maybe slightly off-topic, but relevant to the RBC variable mortgage offerings: My understanding of the variable rate mortgages at RBC (not this RateCapper mortgage) is that if the prime rate goes up, your payments don’t, but rather your amortization extends. This seems to me to be a very good solution to the risks associated with a variable, because the biggest concern is that you won’t be able to meet the payments if the rate goes up too high. Thus, you can play the odds (that variable will on average save you money) without exposing yourself to the risk of your payments skyrocketing. Or am I missing something here?

Hi Brian,

Thanks for the note. RBC’s “fixed payments” are only fixed if you’re paying enough to cover the interest due that month.

This is from RBC’s standard charge terms:

If you are not in Default and your payment is not enough to pay all accrued interest due on the payment date, we will automatically increase your next payment by a series of $2.00 amounts, until the payment covers all accrued interest since your last payment. We do this so that you will pay all the interest you owe us and the amount you owe us will not increase. When this happens it will take longer to pay out your Mortgage. Your payments will remain at the increased amount for the rest of the Term, unless we both agree to a new amount or your payment falls short again.Most lenders’ fixed-payments are similar in principle, although there are some exceptions.

As a result, fixed payments are usually not a way to avoid extreme payment risk.

Cheers,

Rob

One thing that makes me think about this “new” product offering is that the product creators and high-ups at RBC are not stupid (unless they make multi-millions of profit p/a by chance!)

They would have looked closely at the market and realised a potential niche for this product type which given the analysis above can only spell out a downside for the greater (70% +) mortgage buying public who still renew at posted rates and “trust” what their bank tells them

Like most forms of insurance (i.e. a cap), you pay more for peace of mind. The banks price these capped variables knowing full-well that the likelihood of exceeding the cap is so small that it’s almost guaranteed to make them more money. In exchange for the guarantee, of course.

You’d have to really be a nervous nellie to take one of these though…

There is a matter of marketing. If you sell a client something that sounds like they are going to be paying less because “it won’t go up that high” then they will probably believe it. I hope no one accepts one of this, go with the fixed rate, unless you want to play with the mortgage rate. Then go with variable.

You mean RBC does not want mortgage brokers telling people that RBC’s products may not be the best choice??

Thanks for your response Rob! I didn’t know that detail, so that’s definitely something to keep in mind. However, I’ll have to do some number crunching to see how high the interest rate would have to go before a typical payment on a ~20 year amortization wouldn’t meet the interest – I suspect fairly high. Bearing that risk in mind though, the idea of a fixed-payment variable still holds considerable value to me in that payments remain stable and predictable in rate-changing times. I would expect the best way to approach it would be with a payment level that reflects something like an expected average interest rate over the term. Maybe 50 bp below the current discounted fixed rate for that term would be a good starting point? (I believe you can set your payment level at the start of the term for these mortgages at RBC, and maybe even adjust them during the term.) Thus, if rates are actually lower, you pay off faster, and if they go higher you pay off slower, and theoretically (!) you shouldn’t come too far from balancing out in the end. If the actual average interest rate had been picked correctly for the payment level (i.e. you had a crystal ball), my expectation is that this will provide the same effect as variable payment mortgages but without the unpredictability (except in cases of extreme rates). Again, I guess some calculations are in order to determine that.

Thanks for this site, I find it very educational and helpful.

I am at the point of buy a new (to us) home, we’ve shopped around, and RBC has matched a prime minus rate for us (1.9%, variable 5 yr closed), but the mortgage specialist has also offered the rate capper at prime (2.5) with 4.875 being the max rate.

Now this doesn’t seem that bad, a bit more each month (and yes over 5 years if nothing changes it definitely does add up).

I just don’t know where the break point is or if this actually is a decent offer.

Any insight?

Capped variables are almost always a bad deal. Get a regular variable with a big discount instead.

Now the rate cap has dropped to 4.85%, is this still a bad deal? To me, the lower monthly payments is the seller – hands down. I don’t care about paying down my mortgage quickly regardless of the long term interest costs.

With debts to pay down at much higher interest rates, what matters to me is paying the bank the least amount per month… to put that money to work clearing debts with 20% and 25% interest rates… not how much I am saving over 5 years..

Why is that such a bad way of thinking? I am going to have a mortgage for a long time to come being in my early 30s… why the rush to pay it back so fast… regardless of the fact you pay it back 2.5 times over.. LOL

… and in my view the rate capper gives you a low monthly rate for 5 years with the worst case being that you end up in an “interest only” payment each month. So what… why are people so afraid of paying such little principal – or perhaps it is because of my status of being at the START of the front loaded interest mortgage that siginfigant principal payments are a long ways off… and mean little to me. I get more out of the value of my home rising 4% each year than I do in principal payments against my mortgage each month.

Can someone please explain to me why this is such a bad deal? You get a low rate, a fixed amount of risk and the worst case is you end up in a interest only payment. I don’t know about anyone else, but I am in no danger of paying off my mortgage any time soon – fixed, variable, whatever! :)

It’s a bad deal because you can get a regular variable rate mortgage for 1.2% less. The 4.875% cap is not worth it paying 1.20% more up front.

RBC variable rate, closed @ 5 years is -0.15% bank prime. Rate capper is bank prime (0.0%).

Staying with RBC only, it costs you 0.15% more in interest payments for a cap of 4.85%.

Brokers are fine and could give me a better deal as you indicated – but I need some of the products and services offered by RBC for things other than my mortgage and for me, its easier to stay there.

So taking out the broker option, then we are talking about 0.15% interest increase for a cap and a little peice of mind. Also, with regards to negative amortization – I confirmed with RBC that they will not allow that to happen and renegotiate your payment before allowing your mortgage to go into negative amortization.

Has anyone has any experiance with negative amortization and how the banks deal with it? That is the real risk to anyone in a variable rate where the rate is on an increasing trend and if you base your payments on the current low 2.5% bank prime rate.

Is there any way to avoid negative amortization? In a closed mortgage are you locked into the payment amount regardless and your only recourse to combate negative amortization is extra payments?

Thanks all!

Hi Jason,

I’m with you. If you have to stay at RBC then 0.15% extra for a 4.875% cap is peanuts.

That said, I’m really suprised RBC wouldn’t match market rates on a regular variable (assuming your application is reasonably strong).

Regarding negative amortization, RBC’s standard charge terms stipulate that:

(If) your payment is not enough to pay all accrued interest due on the payment date, we will automatically increase your next payment by a series of $2.00 amounts, until the payment covers all accrued interest since your last payment. We do this so that you will pay all the interest you owe us and the amount you owe us will not increase. When this happens it will take longer to pay out your Mortgage. Your payments will remain at the increased amount for the rest of the Term, unless we both agree to a new amount or your payment falls short again.Long story short: They won’t let you go underwater if your payments aren’t enough to cover the interest due.

Cheers,

Rob

Thanks Rob! I never saw that information before however I did read these options in addition to what you mentioned:

* If you choose a closed mortgage, you may prepay up to 10% of the original principal amount of your mortgage once in every 12-month period. The prepayment is applied directly to the principal of your mortgage.

* You may also Double Up your regular mortgage payments (of principal and interest).

* You can make a principal prepayment of $500 or more to your open mortgage as often as you like!

* Plus, you can make principal prepayments of any amount you wish on your mortgage principal at renewal time.

Cheers!

Jason

Oh and this too (LOL):

Once in each 12-month period, you can choose to increase the amount of your mortgage payments by as much as 10%, without administration fees. and the increased payment amount goes directly toward reducing your principal.