Moneyville’s flawed logic on variable rate mortgages

This morning I stumbled upon a new article on Moneyville that discusses the reasons to choose a variable rate mortgage. A particular point that stood out in the intro is ” Now may be the time to go variable.”

Really?

Given that the spread between a 5-year fixed and a 5-year variable is now less than half a percent, I personally would have a serious problem with giving blanket advice like that.

Another point in the article that I found rather interesting:

“Although the central bank rate has not changed much over the past year — and is not expected to soon — lenders have been narrowing the gap between the two rates. That means it’s a good time to consider a variable mortgage before the gap gets even smaller.“

I hate to be the bearer of bad news but some lenders have wiped their decrement to prime entirely while others are very close to following the same route. In fact, some of the major banks are already advertising a 5-year variable at prime plus as opposed to prime minus. Even if one gets their lender to make a rate discretion, the savings over the institution’s posted rate would be rather small at today’s rates. The only consumers who are at a clear advantage right now are those who locked the decrement to prime a few weeks ago when prime – .75% or lower was available plentifully. Consumers who have not locked the decrement to prime while rates were low would be paying a premium that reflects the increased volatility in the credit markets.

While lenders are increasing their variable rates, bond yields have reached historical lows and this turned the advantage, at least in some instances, to a fixed rate mortgage. For example, a 2-year fixed is currently priced at 2.49% or prime – .50%. A 4-year fixed is priced just under 3%, less than prime rate in fact. Considering that the Bank of Canada doesn’t have much headroom to cut its benchmark rate anyway (it’s currently at 1% and while the economy is currently experiencing slower growth, there’s broad consensus among analysts that further rate cuts will not happen unless things really take a turn for the worst), I personally don’t think the case for variable is as clear cut as presented in the article.

Borrowers who opt for a variable rate mortgage would likely stick with variable rates and bet that rates would decrease in the future. However, even if the Bank of Canada decreases its benchmark rate, there’s a  possibility, in the midst of another credit crisis, that financial institutions may not pass on the full savings to the consumer (a practice that’s actually quite common in Europe). When the Bank of Canada cut its benchmark rate to nearly zero during the 2008/2009 financial crisis, the banks were initially reluctant to pass the full cut to consumers.

If the debt crisis in Europe morphs into another international credit crisis, and certainly there are indications that the interbank lending market is already feeling the pressure, variable rates could actually increase in the short-term. Even if prime remains static, lenders can change the pricing with an added increment/decrement (obviously consumers who locked the spread won’t be affected). Remember when variable mortgage rates went from prime – .90% to prime + 1% at the peak of the crisis? As long as the economy remains anemic and the European debt crisis remains unsolved, investors would likely not rush into more risky asset classes. They will leave their money in government bonds and this would keep yields low, making fixed rates more attractive in the short-term. Of course, this is merely a hypothesis. But looking at current economic indicators, it appears that we are entering a period of stagnant growth and investors would likely be pursuing a more conservative strategy.

The article presents a quick payment computation based on a 5-year fixed at 3.20% and a 5-year variable at 2.60% (prime – .40%) to show how a consumer can save “$2,700 annually on a $450,000 mortgage.” Wise consumers should take such examples with a grain of salt.

First, we have no way to know what variables were used to reach this result. What is the amortization? What are the payment terms? How is the interest rate on the variable mortgage compounded? What are the homeowner’s objectives as far as prepayments? After all, small prepayments spread throughout the year offer noticeable savings in the long term. Did the borrower consider keeping the payment amount the same as the fixed rate while capitalizing on the lower variable rate? This would magnify the savings in the short term.

Second, it’s nonsensical to assume that variable rates will remain the same for 5 years and devise a mortgage strategy based on such projections.Variable rates haven’t been steady when the Bank of Canada’s benchmark rate was nearly at zero during times of economic distress. When the economy emerges from a slump into resilient growth, the benchmark rate can fluctuate even more as the Bank of Canada would tweaks interest rates to ensure that they don’t impede growth or overstimulate the economy. As its benchmark rate is currently at only 1%, the only tweaks from here are upwards. Unless the author has a crystal ball that sees the economy remaining in the same state for five years, the example presented in the article, which doesn’t even take the borrower’s risk profile into account, is highly flawed.

Regarding the five reasons about why variable mortgages are a win over fixed rates:

1) Variable mortgages are historically cheaper: While it’s true that variable rates have historically paid off the mortgage faster and with less interest, an economist for the same bank quoted in the article as a reference actually said in a recent interview with Rob Mclister of CMT that in the long run, “borrowers won’t see the same advantage to variable rates as they have in the past 25 years”.

2) Variable rates are near historical lows: Actually, the historical lows were reached back in 2009. Consumers who locked in a variable rate mortgage at prime – .90% just before the financial crisis erupted paid an interest rate of as little as 1.40% as the Bank of Canada lowered its benchmark rate to nearly zero and prime decreased in tandem. As mentioned previously, today’s 5-year variable rate is priced close to 3% and with some lenders it’s priced just over 3%. Hence, while today’s variable rates are still competitive at 3% to their historical range, they are not at historical lows.

3) Variable rate penalties are typically lower: That’s correct. However, some lenders (though not many) charge an IRD to discharge a variable rate mortgage and some banks actually charge a renewal fee on variable mortgages which erode some of the rate savings. Moreover, some institutions register variable mortgages as collateral charge which would result in additional legal expenses to transfer-out the mortgage in the future. So while the penalties would be lower, it’s far more beneficial to look at the overall costs as opposed to just the penalties.

4) You can lock in at any time: While it’s true that most lenders offer this option, there are a couple of limitations. First, almost no lender guarantees the lowest discounted fixed rate upon conversion. In fact, only two lenders guarantee it and actually put it in writing in the current commitment and neither one is a major bank. Food for thought: what’s the point of converting to a fixed rate if you’re going to pay posted or “special offer” rate? The fact that most consumers would be paying a higher fixed rate upon conversion than other consumers who are taking out a mortgage at the same time means that it’s not exactly a free conversion after all. Second, there is a minimum fixed term with all lenders that you must commit to upon conversion (usually 3 years) if you wish to avoid penalties and discharge fees. Third, most lenders don’t allow a blend with a variable rate mortgage.

5) “You start saving right away. Because of the current spread between fixed and variable rates, the savings are immediate. Even if interest rates rise, the increase would have to be big enough to wipe out the savings reaped at the beginning of the mortgage.”: I’m still laughing at this one, especially since most lenders are now at or nearly prime and given that some fixed mortgage terms are actually priced lower than current variable rates. In fact, today’s 5-year fixed rates are inching closer to 3%. With a risk premium of 20bp to lock the rate for 5 years, even variable rate evangelists such as myself would have no hesitation recommending a 5-year fixed as long as the mortgage is planned properly and the homeowner is aware of the fees to discharge the mortgage before the term matures.

With a proper mortgage planning strategy, you can save money with a variable rate but it’s important to understand the limitations. The Moneyville article, in my opinion, shows exactly how not to pick a variable rate mortgage and the logic used in the article is quite flawed based on today’s circumstances.

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