With mortgage rates spiked, how will people borrow?
Easy answer – most of them will lock up. Blame the recency effect. Humans tend to believe that whatever just happened (rising rates, dropping condos, Miley Cyrus) will go on forever. For the past couple of years, with the feds warning of higher interest, folks have rushed to cement their loans. Now a massive 85% of borrowers have mortgages of five years or longer.
Just what the banks want. That’s how they make bales of money – as was in evidence Tuesday morning.
In fact, coming off a week when everyone was yakking about higher rates to come, TD published a consumer advisory which asked the question, “Should I go variable or fixed?”. You will never guess what the answer was:
Based on the possible course of short-term interest rates as projected by TD Economics, we might be at a point of inflection where locking into a fixed 5-year rate could actually provide interest cost savings relative to a VIRM over the next 5 years. Locking in at today’s special 5-year rate at 3.8% would compare with an average VIRM base rate of 4.1% through 2017. Again, this is just an illustration of what the average interest rate on a five year mortgage rate could be given our interest rate outlook.
Really? This projection is based on a Bank of Canada increase of a full 1%, which will happen, but not starting (thanks to a crappy economy) until a year or so from now. When they come, the hikes will be in careful, bite-size, digestible chunks – which means the current 3% prime might not hit 4% until 2014. After that, all bets are off.
So, what’s the best way to borrow? A VRM can be yours at the moment for as low as 2.4% at some no-name mortgage company which also manufactures muffler hangers. At the major banks, it’s 3%. This compares with a five-year fixed rate of 3.79%.
Running those numbers, there’s absolutely no contest which is the better deal. Locking in a 3.79% will result in a monthly of $2,058 and interest costs over five years of $70,452. At the end of the term you’d have repaid $53,075 and still owe $346,724. With a variable mortgage at 3% the monthly would be almost two hundred less, at $1,896 and the total interest bill end up being $55,827. You’d repay $57,983 in principal, and end up owing $342,016.
In other words the variable rate (at 3%) costs less a month, reduces interest payable by almost $16,000 and repays the mortgage faster – by over $4,000. Not only that, but studies have consistently shown that a VRM, over multiple decades, is the cheapest way to finance.
The danger in this? Variable-rate loans are just that – variable. When banks raise their prime rates, up go VRM charges as well. And even though your monthly payment doesn’t fluctuate, the amount of interest being generated does. So as the cost of money increases, more of your payment goes to interest, and less to principal. For example, if rates popped 1%, then that VRM on a $400,000 loan would spawn about as much interest as the fixed-rate mortgage.
Is it worth the risk?
You bet, since most lenders will let you convert a variable into a fixed with a phone call. That means you can finance at 3% or less (if you need a muffler) for at least a year, then flip over to fixed if the economy improves enough to prompt central bank rate hikes. And remember – just because the Bank of Canada ups its benchmark rate does not mean long-term mortgages will move in lockstep. For that you have to look to the bond market – where prices are rising (as stock markets wobble) before the missiles start flying over Syria.
The bottom line is predictable. If you use your turn signal in parking garages and always put the seat down, then lock in. Otherwise, be variable. You only live once, baby.