Economist Predictions & Term Selection

rate-predictions (2)No one truly knows where interest rates are headed. Yet, despite vast margins of error, all major financial institutions regularly publish rate predictions.

If only we could assume that these economists were right – or even half right – it would be far easier to determine the lowest-cost mortgage term.

That’s not possible of course, but what if we pretended for a minute that today’s long-term rate forecasts were indeed accurate? With this hypothetical, we’ll estimate which mortgage term offers the best value and see if any conclusions can be drawn.

It’s first worth noting that few reputable sources publish rate forecasts beyond two years. TD Bank and Desjardins are two FIs that do. Below is a chart showing mortgage rates for the next four years, based on an average of their forecasts.¹


(Click to enlarge)

If rates evolved as you see in the above chart (i.e., if TD’s and Desjardins’ consensus forecasts turn out to be right), today’s 2.99% five-year fixed would easily outperform a 5-year variable. Its projected savings versus a variable would be more than $8,000 over 60 months on a $250,000 mortgage.²

In fact, a 2.99% five-year would beat virtually every other mortgage term based on interest cost to maturity. (The one possible exception would be a 10-year fixed but its performance would depend heavily on rates in years six through ten.)

Unfortunately, actual rates always vary from economist projections, so one hypothetical alone provides only limited value. We typically do a series of them when advising clients and couple that with stress-testing (i.e., determining the rate exposure someone can withstand at renewal) and evaluating the applicant’s goals and finances.

Interestingly, research confirms that economists habitually overestimate future rates when current rates are below average—as they are today. Given that, let’s run a second simulation and see how mortgagors would fare if TD and Desjardins were only half right (i.e., if rates rose by only half of the amount they predict). The graph below illustrates this scenario.


(Click to enlarge)

In this sample case, where rates rise more gradually, a 2.99% 5-year fixed still beats a prime – 0.40% variable. The best hypothetical value of all, however, is the 1-year fixed—if you can find one near 2.39%.

Given the above rate scenario, a 1-year fixed strategy entails a $2,700 savings versus a 5-year fixed in our simulations. That’s measured over 60 months and assumes you renew into successive 1-year terms.

The 1-year fixed turns out to be a reasonable play for well-qualified borrowers who can handle the renewal risk and have sufficient savings or equity and/or a shorter-than-average amortization.

Given future uncertainty, however, the 2.99% five-year fixed remains a tremendous value. It performs well in most rate increase scenarios and is particularly appropriate for conservative borrowers who don’t need to break their mortgage for five years (which would entail penalties).

If you assume a higher probability of rate increases than rate decreases, the cost of picking the wrong term is lower in a 2.99% five-year fixed than in a short term or variable rate. That has seldom been the case historically. In today’s market, that makes the venerable 5-year fixed the best value for most borrowers.

Note: There are numerous other factors that guide term selection. As always, consult a mortgage professional for a recommendation specific to your circumstances.

¹ Desjardins’ forecasts are based on annual average rates. We’ve extrapolated those rates into year-end forecasts. That helps us average them with TD’s numbers. The 5-year fixed rate in the charts is based on a 150 basis point spread above the government of Canada 5-year bond. The 5-year variable is based on prime rate, less a 40 basis point discount. Since TD and Desjardins don’t forecast past 2016, our hypothetical term comparisons assumes that rates plateau in 2017.

² Assumes a 25-year amortization with no mortgage changes required before maturity.

Rob McLister, CMT

  1. The good news is that the choices are between cheap and cheaper. It’s never been less expensive in terms of interest to choose the wrong term, but as you rightly point out there can be other costs associated with the choice.

  2. I do believe these economists will continue to downgrade their predictions just like they have been doing over the past few years. I recall about 2 years ago, their predictions where that prime would be around 4% by the end of this year and that’s obviously not going to happen…
    With the US fiscal cliff and Bernake’s comments that US rates will stay put into 2015, Carney is handcuffed. If he raises rates too fast not in sync with the US, the CDN$ could go to $1.10-$1.15 per USD and what will that do to out ecomony?
    In addiiton, Europe is nowhere close to being fixed and will continue to drag on the global economy for years to come.
    I just don’t see how those rate forecasts will come to fruition? Japan has been at near zero rates for what 20 years? Who’s to say the US and us in Canada can’t stay at near current rate levels for the next 5 years? Canada is viewed as a safe haven out there in the world and countries will continue to buy our bonds and keep fixed rates low for the foreseeable future.
    Just my opinion. We all have one.

  3. Hi John, Odds are that most folks with a prime -.90% variable are better off riding it out. But there are exceptions depending on things like how much time you have remaining on your term, your financial circumstances, future mortgage needs, etc.

  4. Like Leo, I doubt the first scenario will come to fruition. However, prime could easily rise 1.00% to 1.50% in two years.

  5. Rob, you referenced the 1 year fixed scenario with repeated renewals into a 1 year fixed product. The concern I have with this strategy is that most, if not all lenders, will not cover the legals and appraisal costs associated with a renewal or switch into a 1 year term. This means that to avoid costs a borrower would have to renew with a 1 year term with the same lender year after year. This could work, but as we know the best rates on 1 year terms shifts between lenders from time to time. (I know rate isn’t the only consideration) So today’s best 1 year rate may be a good strategy but next year the borrower may be at a disadvantage if he wants to continue with the short term product strategy.
    Your thoughts?

  6. I really would like to know what dart board the economists are using. It must look rather unique or their aim is way off.

  7. Hi Adam,
    It’s a great question. You’re absolutely right that many lenders don’t pay switching costs for one-year terms. Fortunately there are some that do. I’ve also seen certain brokers willing to offset part of these costs. Appraisals in particular are often absorbed by the lender or broker.
    In addition, retention departments are generally eager to keep 1-year clients–especially when they’ve paid a broker for the referral. As such, they often match the best market rates to maintain the relationship.
    And of course, if the rate savings at the new lender is significant enough, that may cover the switching costs (depending on the loan amount, etc).
    Where it becomes more challenging is if the client has a secured line of credit or aversion to inconvenience. Those sorts of things may impact someone’s decision to choose a 1-year term due to the renewal cost/hassle. That’s why we stress that folks need to speak with a mortgage adviser for personalized advice.
    As one final point, when the first 1-year renewal comes up, we do this analysis all over again. That’s because rates and options change constantly. At that time, some clients will be better off renewing into a longer term, in which case switching costs may be covered by default.

  8. i was wondering you made a short mention about the 10 yr depending on the 6-10 yr mark could it possibly out perform the 2.99 and the peace of mind of no renewals and rate changes being the benefit of the higher rate 3.89 which really is not that high i am getting close to retiring and am concerned about qualifying for my mortgages that I am afraid i have to bring into retirement with me principal res and 2 rentals i’m making money on both rentals though

  9. someone needs to tell carney to give it a rest with his endless warnings of raising the rate…we canucks are not foolish people rushing out to jam full our charge cards with massive debts…we’re careful folk and we’re enjoying the low rates so let us have our financial peace before rates skyrocket again and greedy bankers can once again smile and enjoy their billion dollar plus profits….

  10. The world economy is in the toilet and interest rates are not going up anytime soon. If they do go up, I can’t see it going more than 1% if that. I am keeping my 2.35% variable rate until it expires. Why lock into a higher rate when the risk is very low. Inflation is very low so there is no reason to raise rates.

  11. cldnt agree with you more, kevin….until the world economy improves that low variable is the way to go…

  12. When the “world economy improves” you won’t know it until after the fact. Rates will rise so quick you won’t be able to react in time.
    If economists can’t predict rates, you’re fooling yourself to think you can. Forget the guessing games. Get a cheap 5 year fixed and be done with it.

  13. yea not bad advice..thanx…thinking about it but when one is at 2.5 on the variable and my current mortgage lender aint giving such good rates i’m looking at ducking out early, find a new lender, paying a penalty etc etc…i think i will ride it out for a bit…i think carney is just trying to scare folks with his constant chatter of raising rates…no one else in the world is..i’m not so much predicting rates as just riding with a sure thing — for now…

  14. I disagree with you.
    “Get a cheap 5 year fixed and be done with it.”
    This it’s the strategy banks rely on, so they can screw you when refinancing or moving.

  15. The solution to that is simple. Pick a lender that lets you port, increase and blend with no penalty. Then you don’t have to worry about getting screwed.

  16. The truth of the matter remains is that interest rates will remain low, low, low for a very, very , very long time
    Average Joe says it quite well…that Carney is trying to scare folks…yada et al

  17. The truth of the matter is that you don’t know the truth of the matter. Today’s information can’t be used to predict rates in one year.

  18. I’m considering a 3.89% ten year term. Do you think it’s worth it to lock in that rate for that length of time? Advisor has suggested it as he believes rates will rise and if I go for a 5 year term, which is slightly lower, then when I renew, I might be stuck with a higher rate than the 10 year I’m considering now. Thoughts?

  19. to Tree —
    i’m in the same boat as u….3.89 is a nice rate and u get 10 years peace of mind…the question is locking in now or say a year from now….i would be inclined to wait and thats what i’m doing, kinda waiting to see how the world economy moves…but on the ready…but good luck with your decision..lets see what carney has to say on tues but let me predict…more worry about debt load…well mr. carney, our debt load is house car and food…and how do u escape that sir…

  20. Although someone with a calculator and your exact numbers can probably provide a better answer, this is how I see it:
    -Go 5 years at 2.99%
    -Compare the payment price between the 2.99% and the 3.89% options.
    -Pay your mortgage as though you were on a 3.89% mortgage instead of 2.99% (if a 2.99% payment is $900 and the equivalent mortgage at 3.89% is $1000, then pay $1000 for all 5 years even while you’re on a 2.99% mortgage rate)
    -At the end of 10 years, you’ll likely be ahead unless the rates went over 6.00% when you renewed for the additional 5 years.
    Now, can someone correct my math to put in a bit more precision? :)
    Now, if the rates rose to 6% and you could no longer afford those payments, then an alternative scenario would involve taking the 2.99% mortgage and putting the extra $100 (from the scenario above) and placing it in a low-risk investment. After 5 years, you would have $6000 + investment interest as a safeguard to help pay for whatever the increased payment would be at 6.00%.
    Mind you, these techniques require a lot of financial discipline in order to reach their full potential. Some might see the extra $100 as spending money instead of using it to offset the future mortgage rate increases as they should.

  21. The last time the BOC tried to raise rates, it didn’t last long. House prices are already beyond what many can afford. With the 25 years max amortization, a rise of more than 1 per cent or so in interest rates will price many out of the market. This will cause house sales to drop even lower. The rates would then come down again as they did before. Until debt around the world is under control, forget raising interest rates. The BOC would not dare raise any rates until the Feds do south of the 49th. They are talking maybe 2015.

  22. I do not know exactly when mortgages rates will go up, but information from our client base indicates that a 2-3% increase in mortgage rates will result in a large amount of foreclosures across the country.

  23. I’m at 3.9 right now variable rate…my lender wants to lock us in at 3.25 fixed for 5 yrs…I’m reading all this info but don’t know what to do…my mortgage renewall is due March 2014…
    thoughts anyone?

  24. Looking at renogatiating and like the looks of 3.79% for 10 years. One feature of the vendor is that they have a double up payment option that goes direct to principal with the right to skip a payment for each double up. The great thing is that it allows one to get the interest saving of prepaying with the option of recovering it should one need to. Kinda allows that 3 month expenses in savings financial planners say we should have. I also remember my first mortgage in the 80s at 14.75%! One should look beyond the straight up interest costs.

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