Rates Go Up And Down

Two of Canada’s biggest lenders have cut their posted fixed mortgage interest rates, and economists predict rates may drop even further.

The Royal Bank of Canada led the charge, announcing yesterday that its five-year lending rate would be cut to 5.59%, down a tenth of a percentage point. The Bank of Montreal quickly followed suit, shaving off two tenths of a percentage point to meet RBC’s rate.

Lower Rates Improve Mortgage Affordability
The cuts are welcome news to mortgage shoppers, who must now qualify under the 5-year posted rate according to the new mortgage rules that took effect earlier this year. A drop in fixed rates improves mortgage affordability for those who otherwise might not qualify.

Fixed Falls, Variable Rises
However falling fixed rates are being met with rising variable rates, as in July the central bank raised the prime lending rate another basis point to 0.75%, in the second increase so far this year.

The disparity between fixed and variable mortgage interest rates is not unusual, as they typically respond to different economic cues.

Fixed Rates Follow Bond Market
Fixed rates are tied to the bond market, and when bond yields drop, so do fixed rates. Last week’s announcements by RBC and BMO were in response to an unexpected jump in bond prices, which drove yields down. The gap between fixed rates and current bond yields is still wide enough to allow room for further cuts to the fixed rate, which would take it back to the historical lows seen last year.

Prime Rate Governs Variable
Variable rates, however, are tied directly to the prime lending rate, and move up and down in step with the Bank of Canada’s announcements. When the prime rate was slashed to an unprecedented 0.25% to control the fallout of the global financial crisis, variable rates dropped accordingly, creating the promise of bargain-basement mortgages.

The Pitfalls of Cheap Borrowing
Such great deals, however, may not have been entirely beneficial. Cheap lending rates lured many homebuyers into the market early, swelling Canada’s real estate sales and creating fears of an unsustainable bubble.

Then there are those borrowers who were on the margin of affordability, for whom the historically low rates made the dream of home ownership just barely possible.

Cheap Today, Expensive Tomorrow
Those who took out variable rate mortgages may not be prepared to meet higher payments as the prime rate rises, and those with fixed rate mortgages, while immune from the month-to-month variations, may face a nasty shock at renewal time should fixed rates move higher. Once borrowed, the mortgage balance must be either renewed at the price of the day, or repaid in full, which might see those on the precarious edge forced to sell their homes at renewal time, reinforcing the fears of a real estate bubble.

Tougher Mortgage Rules Reduce Default Risk
It was precisely these concerns over future affordability and the potential devastation of mass mortgage defaults that led the Canadian government to put tougher mortgage rules into effect in April of this year, by requiring borrowers to qualify under the 5-year fixed mortgage rate. This way, even those who opt for lower variable interest rates or short-term fixed rates should have the ‘wiggle room’ needed to adapt to future increases.

Variable Saves Thousands
It is interesting to note that historically variable rates have worked out to be the better deal – in the long run.

A study by York University professor Moshe Milevsky compared fixed and variable rates from 1950 to 2007, and found that most of the time – 89% of the time – variable rates outdid fixed rates. In fact, Professor Milevsky found that a $100,000 mortgage on a variable interest rate would save a staggering $20,000 in interest payments over just 15 years, compared with a fixed rate.

Variable Means Variations, and Requires Planning
However the short-term variations in monthly payments may not be sustainable for some borrowers, and therein lies the rub. Without careful planning, such as setting money when variable rates are low to meet increased payments when rates go up, most people’s budgets won’t allow for paying double, or triple, in tough times.

So many borrowers choose to pay more over the long term in exchange for the stability of monthly payments, rather than risk defaulting on payments should variable rates soar.

Prime Rate Set to Rise
While Canada’s prime rate remains extremely low, even after two increases this year, there are indications that future increases are in the pipeline. Some analysts predict the prime rate could go as high as 4% in the next couple of years, though the Bank of Canada is moving cautiously so as not to destabilize Canada’s yet-fragile economic recovery.

Canada remains the only G7 nation to raise its lending rate in the wake of the financial crisis.