The (almost) sure thing

Mr. Bond Market shoved rates higher again Wednesday. So bond prices were down. Rate-reset preferreds went up. The stock market was less vexed. And variable mortgage rates kept falling.


You may have noticed that as fixed-term, five-year loans jumped in recent weeks, the big banks turned around and inexplicably reduced the cost of VRMs. In fact, there’s a mini war raging now and so far HSBC is winning. The variable rate there is more than a full 1% below the prime rate, and the bank is also aggressively going after new HELOC business, offering those lines at the prime rate (3.45%) without the usual half-point (or greater) premium the other guys charge.

Of course, HELOCs are variable-rate as well. So what does this mean and why is it happening?

Mortgages come in essentially two flavours – open and closed – and rates come as fixed or variable. Open mortgages can be paid off at any time without penalty, so they’re rare. Lenders would rather have you firmly by the shorts for many years. Most people (70% or so) opt for fixed-rate mortgages with five-year terms because the payments are never-changing and the loans have predictability. Variable rate ones change along with bank prime, which reflects moves made by the Bank of Canada. These days rates are increasing, a trend with legs.

But variables are cheaper than fixed. The average locked-in fiver is around 3.3% but the variable version is a full 1% less (the best deal in seven years). That appeals to people who have over-leveraged (they might also want a longer amortization to reduce payments) and want the lowest monthly bill possible. The catch (as mentioned) is that rates are rising and VRM borrowers could be caught in that trap.

Typically a bank will allow you to keep steady monthly payments for the term of the loan (normally five years, but you can choose less) even as the interest rate accelerates with prime. But as rates augment, less of your payment goes to principal and more to interest. If rates were to increase significantly over five years, it’s conceivable you’d make payments for 60 months and still owe what you did on day one. Unlikely, but it’s happened before. Most VRMs come with an escape hatch, however, allowing conversion to a fixed-rate loan part of the way through the term if you chicken out.

Why are the banks aggressively chopping variables? Should you get one? Trevor wants to know:

We are a family with 2 kids age 3 and 7 and have an annual income with $220,000 between the wife and myself. For our house that’s valued at $600,000, and still has a mortgage of $300,000 to be paid off, I have 2 questions where we could use your guidance

1) We are renewing our mortgage, and these are 2 options to choose from, which one would you suggest/vouch for?
5 year fixed 3.24%
5 year variable 2.16%

2) Should we pay off the mortgage in the next 5 years by paying about $5,000 monthly installments but cheap out on max TFSA/RRSP savings? or should we take our time to pay the mortgage (may be take 10 years instead of 5 years) but max out on TFSA/RRSP first?

First, if your finances are shaky, your spouse is about to run off with his Zumba instructor or you have triplets coming, get a fixed-rate mortgage. You don’t need more surprises. Otherwise, the fact the spread between fixed and VRM is 1% or greater poses a compelling argument for taking your chances on rising rates. The Bank of Canada would have to up its trendsetting rate at least four times for you to stop benefiting over a fixed rate. While there’s a large chance that will happen, it could take a couple of years to materialize – during which time you’re saving money. If the economy tanks in the meantime, higher rates might be stalled out completely.

Down the road if you did decide to switch to fixed, the penalty for doing so would typically be small (compared to breaking a traditional mortgage). So, Trev, why not sign up for that cheapo 2% deal?

However, bloating monthly payments to $5,000 to trash the mortgage at the expense of investing in TFSAs or RRSPs is just emotional. So please get the unruly, hormonal right side of your brain under control. Why pay off a 2% home loan when money invested in a tax-free investment vehicle can return three or four times that? Especially if real estate has peaked and may be flaccid or even descending over the next half decade? No logic there. Build up the investment assets, then use the gains to apply to the mortgage principal when it renews. Much better path.

By the way, why do the banks want you to go variable? (a) You’ll borrow more and (b) they got ya.

Collateral damage

Realtors made official Tuesday what this pathetic blog has been telling you lately. And look at the words used describe things: “destabilized,” “lowered,” and (my fav) “collateral damage.” The numbers pretty much speak for themselves:

  • Sales were down on average across the nation by 14%.
  • April is always better than March. But not this year. Big drop.
  • 60% of Canadian markets are going in reverse.
  • The price of houses nationally has fallen 11.3% in a year.
  • The most damage is being done in the GTA and the LM. No surprise there.
  • Blame the mortgage stress test.

“The stress-test that came into effect this year for homebuyers with more than a twenty percent down payment continued to cast its shadow over sales activity in April,” says CREA’s president. “This year’s new stress test has lowered sales activity and destabilized market balance for housing markets in Alberta, Saskatchewan and Newfoundland and Labrador Provinces,” says the group’s economist. “This is exactly the type of collateral damage that CREA warned the government about. As provinces whose economic prospects have faced difficulties because they are closely tied to those of natural resources, it is puzzling that the government would describe the effect of its new policy as intended consequences.”

What a suite of problems faces housing. The stress test, sure. But also those damn taxes – on Chinese dudes, Albertans with cottages, people with vacation condos, second homes, pied-à-terres or under-utilized lovenests. Layered on is the quantitative tightening of central banks. After almost a decade of slathering liquidity over the economy, they’re now hoovering it up.

And this is what it looks like:

Behold the spike in yield yesterday for the five-year Government of Canada bond. That happened while US Treasuries were also romping higher, causing the stock market to sell off a little as investors resigned themselves to as many as three more rate hikes this year by the Fed. With 10-year, risk-free bonds now paying more than 3%, why take a gamble to get 4% with a stock that could decline in value? So, equities fade.

By the way that bond chart above is meaningful if you have a mortgage renewing this year. The banks’ lending rates are closely tied to the yield on five-year government notes, so this will give you an indication of where things are headed. No, rates are not spiking, exploding or careening higher. It’s more like the water in Grand Forks – every day it creeps up your pant leg a little, and there’s not a thing you can do about it. Except leave.

Clearly that’s what a lot of people are doing. Today’s numbers confirm buyers have retreated during what is normally the peak season for residential real estate. This suggests when spring’s over and the summer doldrums hit, followed by the next icy blast, the market could be further destabilized. Damaged. None of the big factors – the stress test, punitive taxes nor rising rates – will be gone by the end of 2018.

Nor will politicians. The series of blunders being made by governments at all levels is epic. Raising taxes will not lower house prices, for example. And now comes word (C.D. Howe Institute) that provincial over-regulation and municipal gouging have added $168,000 to the price of the average new GTA house and boosted the cost of a new-build in Vancouver a stunning $644,000. In other cities, more pain – an extra $264,000 in Victoria, $152,000 in Calgary and $112,000 in Ottawa.

There’s a reason houses in the States cost a fraction of what they do here, where people make about the same and families are less in debt than they were a decade ago. Keep voting the way you are and we’ll soon be buying yurts.