What are the implications for Canadians with mortgages of the Bank of Canada’s decision
on September 7, 2005 to raise short-term interest rates by a quarter point –as well as possible additional rate hikes over the next few months?

This question is of interest to mortgage holders and prospective home buyers alike, as any increase in the Bank’s overnight rate directly influences the Prime rate –and what consumers pay for a variable mortgage.1 The prospect of a rising rate environment adds salience to the debate of whether one should hold a variable rate mortgage or “lock-in” one’s costs with a fixed rate mortgage.

This paper presents two potential rate hike scenarios and examines the effects of each hypothetical “tightening cycle” on consumers with variable loans and those with five-year fixed loans, two of the most commonly-held mortgage types in Canada.2

Scenario One assumes five consecutive rate hikes of a quarter point, beginning with the September 7, 2005 announcement and continuing with the next four regularly scheduled Bank of Canada rate announcements, until March 2006.

Scenario Two assumes a more gradual tightening of five quarter-point rate hikes, beginning with the September 7, 2005 announcement and continuing every six months through to September 2007.

These scenarios are based on mortgage rates as of September 6, 2005, when a competitively discounted five-year fixed mortgage rate was available at 4.50 percent, and a competitively discounted variable rate mortgage could be obtained at 3.40 percent (the in effect 4.25% Prime rate less a discount of 0.85 percent).

How likely are these scenarios? The futures market for Banker’s Acceptances shows that professional money market traders are expecting short term interest rates to show an increasing trend until at least the middle of 2007.3 The expected increase is however more modest than either of our scenarios with a total expected increase in short term interest rates of approximately 60 basis points (0.60%) between now and June of 2007. This is less than three 25 basis point rate hikes over the period.

The futures market for Banker’s Acceptances can be fairly volatile and can be influenced by a variety of economic factors including the human and economic target brought by Hurricane Katrina. These influences can be rather short term in nature and borrowers accessing variable rate mortgages will be exposed to the risk brought by such volatility while those borrowing on fixed rate mortgages will be less influenced by such short term fluctuations.

Andrew Moor, MBA
T: 416.622.6363 ext.150
F: 416.622.4665
andrewmoor@invis.ca

Steven Moyes, MA
T: 604.879.0228
F: 604.879.5611
stevenmoyes@invis.ca

Graph 1:
Chartered Bank Administered Interest Rates –Prime Business
&
Selected Government of Canada Benchmark Bond Yields: 5 Year
January 2000 –August 2005

Source: Bank of Canada

Scenario One: Rapid Tightening Pattern Four Additional Consecutive Rate Increases Over the Next 7 Months

If the Bank of Canada continues to raise interest rates by a quarter point over the next four additional consecutive regularly scheduled policy announcements (for a total increase of 1.25%, including the September 7, 2005 rate hike) at the end of 5 years, on a mortgage of
$175,000 with a 25 year amortization, those with a variable rate mortgage, making identical monthly payments, would be left with $154,842.67 in principal owing, $1199.15 more than those with a 5- year fixed mortgage, who would owe $153,643.52.

In this scenario of a relatively rapid tightening pattern, the 5-year fixed mortgage would offer a more effective means of paying down the principle on one’s mortgage

Scenario One: $175,000 mortgage, 25 year amortization 1. Variable rate: Prime increases four additional times to 5.50% over the next 7 months and remains at that level. Monthly payment: $968.58. Balance remaining at the end of 5 years: $154,842.67. 2. Fixed rate: 4.50%, five year term. Monthly payment: $968.58. Balance remaining at the end of 5 years: $153,643.52.

Scenario Two: More Gradual Tightening Pattern Four Additional Rate Increases Over the Next 24 Months

In this scenario we assume a more gradual tightening pattern –four more quarter-point rate hikes, one every six months, for a total of five hikes over 24 months. At the end of a 5 year period, on a mortgage of $175,000 with a 25 year amortization, those with a variable rate mortgage, making identical monthly payments, would be left with $152,904.61 in principal owing, $738.91 less than those holding a 5-year fixed mortgage, who would still owe $153,643.52.

In this scenario of a more gradual tightening pattern, the variable mortgage product would offer a more effective means of paying down the principle on one’s mortgage.

Scenario Two: $175,000 mortgage, 25 year amortization 1. Variable rate: Prime increases four additional times to 5.50% over 24 months and remains at that level. Monthly payment: $968.58. Balance remaining at the end of 5 years: $152,904.61. 2. Fixed rate: 4.50%, five year term Monthly payment: $968.58. Balance remaining at the end of 5 years: $153,643.52.

The Prime Rate in Relation to Bond Yields

Graph 1 on page two shows the Prime rate for the past five years in relation to the yield on five year government benchmark bonds. Actual pricing of a variable rate mortgage will be Prime minus a discount percentage; actual pricing of a fixed rate mortgage will be bond yields plus a certain percentage. Over much of the last five years, Canada has been in a period of decreasing Prime rate and borrowers with variable rate mortgages have benefited as rates declined. With market expectations, and Bank of Canada’s own actions, leaning towards increasing Prime rates it is unlikely that a borrower with a variable rate mortgage will see the same advantage over the next five years as a borrower who accessed a variable rate mortgage at the beginning of the decade.

Other Considerations in Deciding on Variable vs. Fixed While any tightening cycle by the Bank of Canada will tend to increase the advantage of hold a fixed rate mortgage, most variable rate mortgage products have “lock-in” provisionswhich allow the mortgage holder
to switch to a fixed rate product at any time during the term of the mortgage.

Some lenders offer low introductory interest rates for a set period, usually referred to as “teaser rates.” These offers are more significant for borrowers who will hold a mortgage for a shorter period of time.

Pre-payment penalties are another consideration for consumers deciding on which type of mortgage best meets their needs. Competitive variable rate products typically have a pre-payment penalty amounting to 3 months –or even 2 months –of interest. Fixed rate mortgage penalties range from a minimum three months interest, to so-called Interest Rate Differential clauses that can involve sizable penalties. For homeowners planning to stay in their current home for less than five years, pre-payment penalty rules will factor into their mortgage decision.

Conclusions

Our research suggests that the advantage of holding a fixed rate mortgage is greatest if a possible Bank of Canada tightening cycle were to happen relatively quickly. If the hypothesized tightening cycle is more gradual, there is a greater likelihood that holding a variable rate mortgage would be to one’s advantage.

With fixed rate mortgages, the homeowner knows with certainty the payments required over the term of the mortgage, providing a degree of comfort that is not available with variable rate mortgages. This certainty provides a measure of insurance against unexpected increases in short term interest rates. On the other hand, short term interest rates would have to rise appreciably in order to diminish the attractiveness of a variable rate mortgage strategy.

Whether to hold a variable or fixed mortgage is a significant decision, however, the September 7, 2005 Bank of Canada announcement to increase rates, and any possibility for more rate hikes does not imply that borrowers should necessarily opt for a fixed rate mortgage. For expert guidance on the most advantageous mortgage strategy for you amidst changing interest rates, please seek advice from your Invis Mortgage Consultant.

1. The Prime rate is the interest rate charged by banks to their most creditworthy and largest corporate customers. The prime rate is used as a base rate for other types of loans such as lines of credit and variable rate mortgages.
   
   
2. A tightening cycle refers to a period in which the Bank of Canada is raising rates to restrict monetary conditions in an attempt to prevent the economy from overheating and causing excessive inflation.
   
   
3. Banker’s Acceptances are financial instruments traded in large volumes every day on the wholesale financial market and are effectively the rate at which Banks borrow money in the market. The rate is set by supply and demand from institutional investors.

Disclosure Statement The above research is intended for the benefit of Invis’s clients and consultants. The research is not intended to provide any specific advice to an individual mortgagee and should not be construed as such. Please consult a licensed mortgage broker, consultant or agent before taking any specific action on your mortgage.

PDF Format Below:
Determining the Best Mortgage Strategy: Fixed or Variable? - Sep 7, 2005

For media comments and inquiries, please contact:

Steven Moyes
604-879-0228
E: Steven Moyes