The Relevance (or Irrelevance) of Mortgage Rate Expectations

Canadian Mortgage Trends, June 10, 2011

Variable-or-fixed-mortgage 61% of Canadians expect higher interest rates one year from now. 24% believe rates will stay the same.

These stats are from a recent 1,000-person CIBC-Harris/Decima survey.

Respondents were also asked: If you had to choose between a fixed or variable-rate mortgage today, which would you select? Their answers:

39% would choose fixed
32% would choose variable
25% were undecided

Mixed opinion/confusion about rate selection is pretty typical. Moreover, peoples’ opinions will change as rates change. If we were in the midst of rate hikes and you polled these same respondents, they’d lean more towards fixed rates (if history is a guide).

But rate expectations are just one criterion in mortgage planning—and a dubious criterion at that (because the forecasts upon which they’re based can change so quickly and drastically).

CIBC SVP, Colette Delaney, says mortgage decisions “should be based on how your mortgage fits with your long term financial goals, not on short term rate fluctuations.” And she’s right.

Falling-rates: Rates have dropped like an anvil. Yet, that has no bearing on rates 12 months from now. Similarly, rates 12 months from now have no bearing on rates 12 months after that.

A mortgage plan is better made by weighing the common mortgage suitability criteria. That means evaluating your 5-, 10- and 20-year financial plan, equity, job stability, projected income growth, savings, liquidity, and risk sensitivity. Generally, the more you can afford to be wrong on rates, the more you can lean towards a variable mortgage or shorter term.

Historical research and rate simulations can also help when choosing a term. For example, as most mortgage professionals know:

– The most prominent mortgage research has shown that 77% of the time (historically speaking) a deeply discounted variable costs less than a 5-year fixed.
– Economists believe a “normal” (policy neutral) Bank of Canada overnight target rate is in the 3.00% to 3.50% range (we’re at 1.00% today)
– Prime rate has risen just over 3% on average in past rate cycles (See “Variable-rate payments Over Time.” This includes the economic cycles since the modern era of monetary policy [i.e. inflation targeting] began in 1991. Prime rate has already risen 0.75 percentage points from the lows of our current cycle.)
– Going forward (apart from occasional and relatively brief rate spikes), analysts largely expect low growth, low inflation, and overleveraged consumers to keep interest rates below their long-term average.

Mortgage planners can use this kind of information to create amortization simulations. That analysis is then used to illustrate the hypothetical borrowing costs of different rates and terms.

Mortgage-Amortization-SimulationWe do simulations like this regularly and clients love them. What these models do best is quantify the potential cost differences between terms. That helps people better understand the price of certainty. (Fixed rates and longer terms provide “certainty” but come with pricier rates up-front.)

It’s vital to remember that simulations rely on assumptions. For example, not only do you have to assume rates will go up, but you have to assume when and how high. Those inputs will invariably be wrong to some degree, and the margin of error is often significant enough to make simulation recommendations invalid. As a result, rate models are always secondary criteria to the client’s financial suitability considerations and should never be relied on exclusively.

At the moment, our rate models (based on the Big 6 banks’ rate projections, historical mortgage spreads and the best rates for each term) suggest the most value lies in a 2.99% three-year fixed — available through select brokers. After that, prime – 0.90% variables and 3.59% five-year fixed terms are neck and neck in terms of lowest hypothetical borrowing cost over five years.

As an aside, people on the fence needn’t give themselves an ulcer when deciding between fixed and variable rates. Hybrid mortgages are a great solution for providing rate diversification. That’s because you can allocate any amount of your mortgage to the fixed or variable portions. For example, you could choose 67% variable and 33% fixed if you wanted to.

If you do get a hybrid, just be sure to choose equal terms (e.g. don’t get a 5-year variable with a 2-year fixed). Otherwise, the lender might stick you with a subpar rate on renewal of the shorter term.

More survey findings: Among younger home buyers (25-34 year olds), just 27% would choose a variable-rate mortgage today. That jumps to 42% in the 45-54 age category.