Fixed Rate vs. Variable Rate Mortgages
Peter Kinch is one of Canada’s best selling real estate authors. You may know him from his titles 97 Tips for Real Estate Investing in Canada and the recently released Canadian Real Estate Action Plan.
Death and taxes – those are the only two things you can guarantee in life. Well, many believe you can add rising interest rates to that list now. We are obviously coming out of the lowest rate environment in our history. Clearly they have nowhere to go but up. Well, at least that’s what the headlines keep telling us. So the natural reaction for most new homeowners is to race to their banks and lock in those rates while they’re still low. But, is that necessarily the best thing to do? Whether to go fixed or variable is one of the most common questions asked of brokers and bankers across the country today. And as much as it would seem that the answer is obvious, it’s not that simple.
To truly answer this question, we must first take a look at what people mean when they say “interest rate.” I’m sure that there were more than a few individuals who were confused by the fact that the Bank of Canada (BOC) raised the Overnight Lending Rate by a quarter point in June and a variety of chartered banks announced that they were lowering their three-and five-year mortgage rates the exact same week. Sounds confusing, doesn’t it? How can rates go up and down at the same time? The fact is, there are two different types of rates and they are governed by two separate factors. One is the Prime interest rate and the other is the long-term or fixed rates.
Whenever we hear about the BOC making a change to interest rates, we are referring to the Prime rate, which dictates variable-rate mortgages (VRMs). The BOC focuses on one of two things:
1.Stimulating the economy
2.Maintaining inflation at a level at or near 2%
Following the sub-prime crisis of 2007, the credit-crunch of 2008 and the global recession of 2009, the BOC’s primary focus has been stimulating the economy. The best way to stimulate an economy is to get people spending money. And the best way to encourage Canadians to spend money is to make it less expensive to borrow. The result was ‘emergency low’ interest rates. As such, we have enjoyed almost two years of the prime rate being at a record low of 2.25% – technically as low as it can go. Obviously, by definition, this would mean that there is nowhere to go but up. And as soon as the Canadian economy begins its full recovery and we are threatened with inflation rising above 2%, the central bank will most certainly start to raise rates (as we saw by a quarter point increase on June 1 followed by a second rate increase on July 20, 2010).
The long-term or fixed rates, on the other hand, are governed by the bond markets. Fluctuations and changes in the bond yields will impact the spread or profitability of fixed-rate mortgages for the banks. The bond yields are a factor of the bond market and, like all markets, the bond market will experience daily fluctuations. The markets are definitely influenced by the BOC’s decisions, so it would be inaccurate to suggest the two are unrelated – but they will most certainly act independent of each other at any given time. This is what makes the game of rate predictions so interesting.
Let’s take a look at the months of April and May 2010, for example. Prior to April, BOC Governor Mark Carney stated that the Prime rate would likely remain unchanged until July of 2010. But this was a conditional promise, based on inflation remaining below 2%. The bond market does what all markets do when factoring in their pricing models – they react to the anticipation of an event more than the actual event itself. Prior to April, the markets were confident in no movement from the Bank in terms of the Prime lending rate, so there was little or no movement in the bond yields. As such, the long-term mortgage rates remained low as well. But the mood of the markets started to shift in April as talk about the Canadian recovery began gaining ground and, suddenly, there was widespread speculation that the BOC would not wait until July to raise rates and could do so as early as May or June. The bond market reacted by ‘pricing in’ an anticipated increase to the Prime lending rate. Bond yields were affected and, before we knew it, there was a surge in the cost of long-term funds for Canadians. A lot of people were caught off guard by the sudden rise in rates and fears started to mount about the ‘End of Cheap Money’. In the meantime, the BOC did not raise rates in April, so guess what happened to the bond market over the following weeks? It settled down and the long-term rates began to drop again.
As the June 1st BOC rate announcement began to approach, we started seeing the exact same thing happen again. Widespread speculation (‘Would they increase rates by a full half point this time??’) began to set in and, just as it did in April, the bond market started to price in what they thought the BOC would do. And, again, the five-year mortgage rate at your bank began to rise. Then came the long-awaited news on June 1 that, after over a year-and-a-half of no change, the BOC was going to raise the overnight lending rate (which dictates the price of the Prime rate) by a quarter point. And, as expected, the headlines across the country screamed ‘Interest Rates Double’, ‘The End of Cheap Money’…. What they didn’t say was that they were referring to the overnight lending rate changing from a quarter point to a half point, which meant that the BOC Prime rate went from an historic low of 2.25% to 2.50% – hardly a shift to expensive money, but a change nonetheless. The more interesting thing to note at the time, though, was not what the headlines said, but how the bond markets reacted. The bond markets had priced in as much as a full half point increase in Prime. So, in fact, the long-term rates had already been pushed higher in the weeks leading up to the BOC decision. Once the decision turned out to be a lower increase than the markets had priced in, guess what happened? That’s right – the market adjusted – the cost of borrowing dropped for long-term money and virtually every chartered bank lowered its five-year rate the day after the BOC raised Prime by a quarter point.