Mortgage Rates – Is It Time To Gird Our Loins?

by Andrew Pyle, for Yahoo! Canada Finance
Thursday, May 13, 2010

Now that Europe appears to have bought itself some time from those vicious currency and bond speculators (and what a price tag, at a cool trillion dollars), individuals are also feeling a little more relieved about their finances. And they are indeed quite eager to put May behind them. Where investors were lulled into a sense of false security during April, as equity volatility fell to the lowest level since July 2007 (as measured by the VIX index), the spike in volatility this month knocked people off their chairs. True, the high in the VIX last week of just above 40 was still only 50% of the peak seen in November 2008; however, it has served as a wake-up call that there are as many risks out there as rewards.

For now, though, let’s assume there are no further shocks to the system for the coming weeks and that volatility subsides. The focus for individuals and households should then return to their own fundamentals. What does the job and income situation look like? Are financial plans still intact? And what about that mortgage coming due next month?

Ah, the dreaded mortgage decision. Despite the signs of an impending rise in the general level of interest rates and warnings from government officials, I find that there is still a lack of conviction among Canadians as to whether they should lock in their mortgages at prevailing rates, versus holding on to a floating rate mortgage. It’s therefore a good time to review the facts and fiction out there so that you can make a better educated decision.

Regardless of the recent jump in rates, we still look to be in the middle of a downward trend in mortgage rates since 1981. You may remember that year, when five-year term rates were in excess of 22% in Canada. It came at the same time that North America fell victim to a painful double-dip recession. Of course, inflation was also sitting around 12% at the time. Many families lost their homes to be sure, but the threat posed by higher rates today is greater because of the fact that debt levels are much higher today than back then. The increased leverage in the housing sector, to say nothing of general credit among individuals, increases the sensitivity to rates – something we saw so very clearly in the US housing sector from 2003 to 2006.

Today, floating rate mortgages are still trading at various spreads to the prime rate, which itself hasn’t budged from 2.25% since April of last year. How much that spread is will depend on a host of factors, not the least of which is your credit score and perceived credit worthiness by your lender. That said, whether you chose a floating versus fixed rate mortgage doesn’t matter anymore since the new federal regulations went into effect last month. You must now meet the requirements or standards of a five-year term mortgage even if you want the adjustable rate variety. In other words, if you’re not going to budget for the possibility of short-term rates rising to where prevailing five-year rates are today, the government has done it for you.

That five-year rate has been a bit of a bouncing ball over the past year. In April 2009, the conventional five-year rate (or the posted rate) fell to a generational low of 5.25%, coinciding with the last quarter-point rate cut by the Bank of Canada. Through the summer and fall of last year, the rate got as high as 5.85%, but then eased back during the early months of this year as equity markets got a little shaky and bond yields stabilized. That all changed towards the end of the first quarter. Economies were looking a lot better, equities picked up the pace and inflation fears began to creep back in the market. There was also a definite shift in opinion as to when the Bank of Canada would start hiking rates, with the consensus focused on June 1st. Since bond yields needed to price in this new anticipation, other rates went up in sympathy, including mortgage rates as well as GICs. To give you an illustration, the five-year Government of Canada yield rose from about 2.4% in February to 3.2% in April. The five-year mortgage rate, which reached a low of 5.25% in March, shot up to 6.25% by late April. The only relief for borrowers has been a paltry 15-basis-point reduction by banks in the past week to 6.10%. Hardly a surprise when you consider the sharp drop in bond yields worldwide when it looked like contagion was going to put a recessionary grip on the world again.

But, have a look at where things are today. Despite the recent mortgage cuts, bond yields are rising again as investors move money from fixed income to stocks (not what I’m necessarily recommending). Assuming the European calm persists, economic fundamentals in North America continue to firm and China doesn’t upset the apple cart too much with its measures to rein in credit in that country, bonds will likely come under more pressure, sending yields higher. This should pave the way for five-year mortgage rates in Canada to climb to 6.5% and then potentially to 7%. Note, the high before the recession was only 7.5% - a level which could be reached this year under ideal economic conditions.

Now, some will say that it doesn’t matter where longer-term mortgage rates go, since short-term rates won’t likely climb to those levels. This has some merit to it, as the prime rate only got as high as 6.25% prior to the recession. Of course, with today’s spreads added on, the mortgage rate then for some would have been close to the 5-year rate. Whether or not short rates return to those levels depends on a number of things, including inflation, and with world governments still borrowing ridiculous amounts to fund fiscal spending, inflation cannot and should not be ruled out.

All this aside, the decision on which mortgage to chose ultimately comes down to a combination of expectations and emotion. It might seem okay to assume that the stock market won’t experience another meltdown like in 2008-09, but few of us would be willing to throw 100% of our assets into the market on that call. We need to sleep at night and therefore we apply balance to our portfolios. The same holds true for our borrowing decisions. I can come up with an economists’ tale of how interest rates will stay relatively low because of economic headwinds and the increased sensitivity to debt, but what if inflation fears overrule that view?

For those looking to put a household budget together that allows for an extended uninterrupted sleep, the five-year term option is still the best bet. There is also what I call a ‘sticker shock’ factor to keep in mind here. If rates at both ends of the spectrum climb over the next several years, those already acclimatized to a higher borrowing rate will find it less ‘shocking’ upon renewal than the individual with a floating rate mortgage that has to see a continual erosion of their monthly payment towards interest. In other words, the person with the longer and fixed-term mortgage will arrive at the principal amount that was anticipated. The adjustable rate mortgagor will not.

My final point on this has to do with opportunity cost. If the view of rising interest rates turns out to be false, and rates fall or stay flat, then this probably means the economy isn’t so hot. I would suggest in that event that there will be bigger concerns on the household budget than the extra couple of percentage points in interest. In short, this is not a time for aggressive offense, but a good shield.