Coverage in Monday’s Toronto Star
Toronto Star – September 12, 2005 
 
Now that the central bank has finally started pushing up Canadian interest rates, homeowners who have feasted on rock-bottom variable-rate mortgages are faced with the question lock in or let things ride.

Complicating the decision - in a good way - is the fact longer-term mortgage rates remain at near-record lows, for now.

Economists have long argued that going with a floating rate almost always pays off, though the strategy does pose risks if short-term interest rates unexpectedly take off.

But these days you may actually do better by locking in.

To demonstrate the dilemma borrowers face, mortgage broker Andrew Moor creates two scenarios
First, a person takes on a $175,000 mortgage and has a choice of either going for a 5-year closed mortgage charging 4.5 per cent or a variable-rate mortgage currently at 3.65 per cent. Monthly payments are identical and the amortization period would be about 25 years.

The next step is factoring in the Bank of Canada, which directly influences floating-rate loans through its overnight rate. It hiked its overnight rate last week by a quarter point, to 2.75 per cent, in an effort start bringing borrowing costs back toward more normal levels. Commercial banks followed suit by increasing their floating loan rates, including prime.

Bay Street forecasters disagree on the central bank's next step, which is complicated by the uncertain impact soaring energy prices will have on consumer spending and the damage the loonie's latest surge will inflict on exporters. Some say the overnight rate will be as high as 4 per cent by mid 2006; others are predicting mediocre economic growth will force the Bank of Canada to stop at 3 per cent until at least the end of 2006.

Moor, president of Toronto-based mortgage broker Invis Inc., provides two possibilities. In one, the central bank is aggressive and hikes the overnight rate a quarter-point four more times by early March, driving up variable-rate mortgages to 4.65 per cent. The other alternative is an easy-going central bank policy that still raises the overnight rate 1 percentage point but does it over 24 months.

Under the aggressive scenario, a borrower would be better off locking in for five years at 4.5 per cent. The principal would be $1,199.15 lower at the end of five years, or $154,842.67.

If the Bank of Canada takes its time raising the overnight rate, a variable-rate mortgage would be better. The principal would be $738.91 lower.

"The balance of probability suggests that it is still good to be borrowing with a floating-rate mortgage," said Moor. But, he added, the situation is not as advantageous for variable-rate borrowers as it was not so long ago.

That is, even under the scenario that benefits a variable-rate mortgage, the peace of mind from locking in will only cost an "insurance premium" of about $150 a year for a $175,000 mortgage.
About 45 per cent of the 45,000 mortgages Invis arranged last year were based on variable rates, up from 25 per cent five years ago, Moor said.

Now that short-term interest rates are rising and long-term rates are so attractive - the 5-year rate is within 0.10 percentage points from the record low - the trend will move toward fixed-rate mortgages, Moor predicted.

"If you want to sleep at night and not worry about it over the next five years there is less of a premium than we would typically expect for borrowing at a fixed rate."

The Royal Bank of Canada is among the most aggressive forecasters. It is predicting the economy will be strong enough to allow the central bank to raise the overnight rate to 4 per cent by mid 2006, up a further 1.25 percentage points. And it pointed to Friday's strong employment numbers for August as proof.

The good news is that variable-rate mortgage holders will likely have ample time to make decisions because longer-term bond yields, which set fixed mortgage rates, aren't under much upward pressure right now, said RBC assistant chief economist Derek Holt.

"Now is not the time to be panicking," Holt said. "There is more value added to taking a wait-and-see attitude as the markets digest uncertainty over energy prices and Katrina."

Borrowers indeed have the luxury of time to decide about locking in or not, said Doug Porter, deputy chief economist at BMO Nesbitt Burns.

"Effectively, the bond market is expecting the North American economy to cool off and inflation to stay low, so long-term interest rates aren't doing much of anything."

Unlike RBC, which expects as many as five more increases in the overnight rate over the next 12 months, Porter believes three more hikes are more probable.

"The Bank (of Canada) has been pretty clear that they don't foresee a huge tightening cycle."
In the United States the Federal Reserve has been cranking up interest rates aggressively - 10 consecutive quarter-point increases - in a not-so-veiled attempt to take some steam out of what some observers fear is a U.S. housing price bubble.

The situation here is different, said Porter.

"I don't regard housing (as) out of control in Canada," he said. "The market might be getting a little too hot for (the Bank of Canada's) comfort but I don't think it is a primary concern."

So, even with a slow pace of interest rate increases, mortgage holders who are the least bit concerned about rising rates would be well-served locking in soon, Porter suggested.

"It's pretty cheap insurance."

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