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May 16, 2018 | The (almost) Sure Thing

A best-selling Canadian author of 14 books on economic trends, real estate, the financial crisis, personal finance strategies, taxation and politics. Nationally-known speaker and lecturer on macroeconomics, the housing market and investment techniques. He is a licensed Investment Advisor with a fee-based, no-commission Toronto-based practice serving clients across Canada.

Mr. Bond Market shoved rates higher again Wednesday. So bond prices were down. Rate-reset preferreds went up. The stock market was less vexed. And variable mortgage rates kept falling.

Huh?

You may have noticed that as fixed-term, five-year loans jumped in recent weeks, the big banks turned around and inexplicably reduced the cost of VRMs. In fact, there’s a mini war raging now and so far HSBC is winning. The variable rate there is more than a full 1% below the prime rate, and the bank is also aggressively going after new HELOC business, offering those lines at the prime rate (3.45%) without the usual half-point (or greater) premium the other guys charge.

Of course, HELOCs are variable-rate as well. So what does this mean and why is it happening?

Mortgages come in essentially two flavours – open and closed – and rates come as fixed or variable. Open mortgages can be paid off at any time without penalty, so they’re rare. Lenders would rather have you firmly by the shorts for many years. Most people (70% or so) opt for fixed-rate mortgages with five-year terms because the payments are never-changing and the loans have predictability. Variable rate ones change along with bank prime, which reflects moves made by the Bank of Canada. These days rates are increasing, a trend with legs.

But variables are cheaper than fixed. The average locked-in fiver is around 3.3% but the variable version is a full 1% less (the best deal in seven years). That appeals to people who have over-leveraged (they might also want a longer amortization to reduce payments) and want the lowest monthly bill possible. The catch (as mentioned) is that rates are rising and VRM borrowers could be caught in that trap.

Typically a bank will allow you to keep steady monthly payments for the term of the loan (normally five years, but you can choose less) even as the interest rate accelerates with prime. But as rates augment, less of your payment goes to principal and more to interest. If rates were to increase significantly over five years, it’s conceivable you’d make payments for 60 months and still owe what you did on day one. Unlikely, but it’s happened before. Most VRMs come with an escape hatch, however, allowing conversion to a fixed-rate loan part of the way through the term if you chicken out.

Why are the banks aggressively chopping variables? Should you get one? Trevor wants to know:

We are a family with 2 kids age 3 and 7 and have an annual income with $220,000 between the wife and myself. For our house that’s valued at $600,000, and still has a mortgage of $300,000 to be paid off, I have 2 questions where we could use your guidance

1) We are renewing our mortgage, and these are 2 options to choose from, which one would you suggest/vouch for?
5 year fixed 3.24%
5 year variable 2.16%

2) Should we pay off the mortgage in the next 5 years by paying about $5,000 monthly installments but cheap out on max TFSA/RRSP savings? or should we take our time to pay the mortgage (may be take 10 years instead of 5 years) but max out on TFSA/RRSP first?

First, if your finances are shaky, your spouse is about to run off with his Zumba instructor or you have triplets coming, get a fixed-rate mortgage. You don’t need more surprises. Otherwise, the fact the spread between fixed and VRM is 1% or greater poses a compelling argument for taking your chances on rising rates. The Bank of Canada would have to up its trendsetting rate at least four times for you to stop benefiting over a fixed rate. While there’s a large chance that will happen, it could take a couple of years to materialize – during which time you’re saving money. If the economy tanks in the meantime, higher rates might be stalled out completely.

Down the road if you did decide to switch to fixed, the penalty for doing so would typically be small (compared to breaking a traditional mortgage). So, Trev, why not sign up for that cheapo 2% deal?

However, bloating monthly payments to $5,000 to trash the mortgage at the expense of investing in TFSAs or RRSPs is just emotional. So please get the unruly, hormonal right side of your brain under control. Why pay off a 2% home loan when money invested in a tax-free investment vehicle can return three or four times that? Especially if real estate has peaked and may be flaccid or even descending over the next half decade? No logic there. Build up the investment assets, then use the gains to apply to the mortgage principal when it renews. Much better path.

By the way, why do the banks want you to go variable? (a) You’ll borrow more and (b) they got ya.

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May 16th, 2018

Posted In: The Greater Fool

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