What’s this variable rate war between the big banks and what does it mean? Part 2 of 2
By Nick Holloway
As I mentioned in my previous article, the discount on variable rate vs fixed rate mortgage is around 1%, so the question is, how can I take advantage of this? The best way is to look at the numbers, and also take a forward looking approach to what might happen to monetary policy in the next 5 years, but also a side note to remember is that the variable rate typically has a substantially lower prepayment penalty than the fixed rate product which is another good reason to be in a variable rate.
Where are the current Bank of Canada rates again?
Good idea, lets take a look at where monetary policy is today. Currently, the Bank of Canada has raised the lending rate 3 times since July 2017 and we are currently at 1.25%. It is expected that we will have further raises coming, but its important to think about how many and how quickly this might happen. The general consensus amongst economists is between two or three 0.25% rises in 2018. We already had one in January, and the May or June meeting is in the balance at this point, but certainly the central bank have indicated that Canada faces a lot of headwind and slowing growth figures, so they may wait to see what effect the last 3 moves actually has on the economy as these changes always have a lagging effect. If they raise too fast, this may send the economy backwards or they may have to reverse their decision and revert to a lower rate to accommodate.
So Nick, did I hear the Bank of Canada stated they consider a neutral interest rate of between 2.5%-3.5%?
You are right, they did say that! So based on the 5 year term as our time horizon, so lets look at interest rates reaching the lower end of this bracket. If we see an increase of 1.25% in the context of having a 1% discount on the variable rate, this is clearly a win as the rate will inevitably take time to reach, by which time you will have money left over by paying at the lower rate. Or better still, you would increase your payment amount now while the rate is low. The simplest way of doing this is by opting for an accelerated payment schedule, and right now this translates to a smaller payment compared to the fixed rate, with the added bonus of paying your 25 year mortgage down in less than 22.5 years.
Now what if the interest rates go to the 3.5%, well the numbers would have to be looked at but if you opted for the accelerated route, the numbers suggest you are still going to be ahead given you paid down a greater share of the principal before rates increased. If you find your budget is stretched for the increased amounts and above what you might have been paying for the fixed rate, you do have the option to revert your accelerated payment back to the normal payment schedule, or you may be in a variable fixed product, which means your payment amount is fixed for the full term, but the amortization period is increased to reflect the increase in rates.
What if the rates overshoot 3.5%, well for starters I would call this an outlier, but you have to consider the business cycle, it is 10 years since the 2008 crash, and the business cycle is beginning to display expansionary characteristics, but the question is for how long will it continue to expand and will this generate higher inflation which typically results in rates going higher. What will rates look like in 5 years, well the mortgage you enter today will need to be renewed at this time, and the rates on offer then no-one can truly tell you with certainty. With that said, if you see fixed rates come down between now and then, maybe the best option is speak to me and we can look to see if moving to a fixed rate is a good idea.
If you have any questions and want to discuss your mortgage or this strategy in more details, I would be more than happy to help.
What’s this variable rate war between the big banks and what does it mean? Part 1 of 2
By: Nick Holloway
As some of you may have noticed in the media, a number of chartered banks in Canada are running a promotional rate on variable rate mortgages to 2.45%. This has resulted in a spread between the offered variable rate and fixed rate mortgages of around 1% which is an important distinction to make.
Why is this important?
We have to look back at the last ten years and know that we have experienced unprecedented times since the credit crunch and Lehman Brothers going bankrupt in 2008. The result of this turmoil for major central banks across the world has been to implement monetary policy levers, some of which have never been seen before in such a grand scale. The normal levers available are interest rates, the abnormal, if you will, is quantitative easing.
The lowering of interest rates provide the first lever for central banks as a way of increasing liquidity and to prop up economies in times of distress by lowering the cost of borrowing directly and encourage investment and spending. Once this firepower is used up (aside of negative interest rates but that is another topic entirely), the central banks have to find more accommodative ways to stimulate the economy, and the main way they achieved this is through quantitative easing, which is the method of central banks buying government debt (bonds) in massive quantities which drives up bond prices, and as bond yields have an inverse relationship to bond prices, the yields in the bond markets were lowered substantially as a result of the increased buying activity by the central banks. These actions have a similar simulative effect to the economy by lowering borrowing costs and providing increased liquidity to the financial markets.
What does this mean for my mortgage?
Well, there is an important distinction to make in regards to how the rate offered by a variable or fixed rate mortgage is derived. The variable rate is derived as a function of the prime rate, which is in turn directly affected by the central banks interest rate, for the Bank of Canada, this currently stands at 1.25% following the last 3 increases since July 2017. The (5 year) fixed rate mortgages are derived from the bond yields available in the market, and as we are beginning to see the end of the central banks role of buying government debt and with more conventional monetary policy taking over with the rising interest rates, these bond yields have been steadily increasing over the past year or so and the rock bottom fixed rate mortgages we have seen in the past are evaporating.
What should I do?
In my opinion and while I think interest rates are likely to go higher, this is a really good time to take advantage of these low variable rates and if you want to see why, please read part 2 of this article which will give you some analysis on what the numbers might look like and how we can take a view to potential changes over a 5 year time horizon.
If you have any questions and want to discuss your mortgage, I would be more than happy to help.
Canadian Income Survey, 2016
Canadian families and unattached individuals had a median after-tax income of $57,000 in 2016. Median after-tax income increased from 2011 to 2014, but held steady in 2015 and 2016. The slower growth in 2015 and 2016 was associated with the resource price slowdown, which began in the second half of 2014.
After-tax income is comprised of income from market sources and government transfers. Market income includes employment income, retirement income and income from investments, while government transfers include benefits to seniors, child benefits,
Employment Insurance benefits, social assistance and other benefits. While growth in overall median after-tax income slowed in 2015 and 2016, there was also a significant increase in government transfer income. Median income from government transfers rose from $5,800 in 2014 to $7,400 in 2016. About half of this rise was due to increased child benefits, which became a larger source of income for families with children.
In 2014, the median child benefit received by couple families with children were $2,500. This rose to $3,400 in 2015, and to $4,000 in 2016. For a lone-parent family, the median benefits rose from $5,100 in 2014 to $5,800 in 2015, and then to $6,400 in 2016.