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, let’s 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 it’s 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 let’s 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.