Fixed or variable ? This may very well be one of the most asked questions I get as a mortgage broker. Last week, two Bank of Montreal economists, Douglas Porter and Benjamin Reitzes, surprised many people by saying that fixed rate options are a better option to variable rates. Below I provide my own perspective on some of their key arguments.
“Fixed now modestly trumps variable…”
Key BMO Premise #1 - “While we have in the past supported going variable, and even though short-term rates are likely to remain low this year, current offers on long-term mortgage rates and the improving economic outlook tilt the balance in favour of locking in at this stage—fixed now modestly trumps variable.”
Calum Ross Comment - I have never once seen the Bank of Montreal advocate variable in any form or report extensively chaired by their lead economists. Nor have I seen BMO or any other bank promote shorter term fixed products as a lead marketing initiative (could it be because they are less profitable… GASP). While Douglas Porter is an impressive, if not all star economist, he fails to have the intricate understanding of the mortgage market and the way that, among other things, variable rate mortgage positions can be hedged with little to no cost or hassle to the consumer. The reality is the that the basic rate and discounts that they use to do their quantitative analysis are so far off the actual best discounted rates in the market place that the quantitative analysis done by the group actually has very little merit.
In other words, if they used the true “On The Street” discounted rates, their math would come out much differently.
So while it is true that there was the odd reference to BMO reflecting on the merits of variable, their actions speak louder than words. In fact, their marketing and rate discounts offered last spring were clearly leading consumers to move towards the five year no frills BMO mortgage which was not only a fixed rate but also had a few key features missing that could cost consumers even more. My comment – BMO actions will always speak louder.
Historically, variable mortgage rates were the better option
Key BMO Premise #2 - “Historically, there has been little contest on the better option: typically borrowers save money by staying in variable products. Fully 85% of the time since 1975, the cost-effective route for borrowers was to stay variable (Chart 1). But, historically low interest rates have sharply narrowed the spread between 5-year fixed mortgage rates and variable rates. And, at long last, an improving economic backdrop has markets anticipating rate hikes from both the Bank of Canada and the Federal Reserve in 2015.”
Calum Ross Comment – First of all it was not BMO but rather my very own MBA finance professor Moshe Milevsky that produced the most extensive piece of analysis on variable versus fixed. Even then, despite it being the best piece of quantitative research on the subject at the time - it, like the BMO report, failed to use the discounted mortgage rates that are often obtained by consumers through their top performing mortgage broker or bank representative. In reality the research by Moshe Milevsky, while brilliant, significantly missed the mark by using the wrong base rate variable and base rate fixed for the duration of the analysis. To get the math and review right we would need to blend one of the great academic/economist minds with a strong quantitative person in the mortgage industry who understands its more detailed inner workings.
Low fixed mortgage rates may never be this low again anytime soon
Key BMO Premise #3 -“The bond market has sent out loud warning signals over the past year that the era of low interest rates may finally be drawing to a close. For instance, 5-year Government of Canada and U.S. Treasury bond yields neared 2½-year highs early in 2014, on an improving outlook for the global economy and expectations of continued Fed tapering. As bond yields rise, the cost of funds for lenders also rises, ultimately putting upward pressure on consumer and business borrowing costs, including long-term mortgage rates. So, even if variable rates take some time to climb, we may not see such low fixed rates again anytime soon.”
Calum Ross Comment – Hmm… Simply not reality. The tapering is not cutting supply of funds into the market, it is merely moving toward no longer injecting funds into the market. In fact, just to bring the debt capital markets back to the same level of bond supply that was in place when this process started, the Federal Reserve would need to sell $85 billion dollars of bonds. As it stands currently they have not even stopped the quantitative easing… let alone reversed it.
The bottom line on making the choice: Fixed vs variable mortgage rates
We must all be realistic in our decision. Neither Bank of Montreal, nor the Bank of Canada, nor I can predict actual interest rates effectively in the long run. Canada has an export driven economy that depends heavily on our trading partners. Accepting that no one can accurately predict the future is key to making good present decisions. So here is the reality to consider as you look to your mortgage choices:
- In the absence of inflation it is highly unlikely that short-term rates will move up. In fact, in a recent comment, the Bank of Canada even hinted they could reduce their rate. Although highly unlikely, it is a sign that rapid rate increases are simply not in the cards.
- Knowing that, why not choose the lower payment variable, but pay the equivalent payment as if you were locked in. That way, you pay your mortgage down more quickly, you have a built in buffer if and when the variable rates eventually increase in coming years, and you have the flexibility of locking in at a future date. With variable, you are in control, you are paying yourself instead of the bank.
- Betting on timing debt capital markets or equity capital markets is a fool’s game. Never for a second make any mortgage decision that is not consistent with your risk profile and financial tolerance. So, even if you have all the facts, you can’t sleep at night because you have a variable rate mortgage. Choose the lock-in option. Yes, you will pay more (the cost of a good night’s sleep), but if your risk profile prefers surety then fixed is for you.
Rates will move, rate discounts will increase and decrease. Don’t try to guess, make sure you are looking at the facts, what your plan for the property is and your personality before you just blindly jump into a locked-in rate, just because the bank says it is the best option. I ask ‘Best option for who, me or the bank?”
Written by: Calum Ross