Floating-rate mortgage cheaper in the long run

Monday, June 28th, 2004

Gary Norris

RISK-TAKING I If you’re like the people in TV commercials, you may have recently discussed this issue with your spouseNULL or long?

Choosing a mortgage term is a decision that says as much about your personality as it does about your economic analysis. It also depends on how close to the edge you are financially.

Just don’t try to pretend that it’s based on an acute forecast about the future level of interest rates.

Global financial institutions devote massive intellectual and technological resources to predicting rates, but frequently it seems they might as well flip a coin. It would be unwise to bet your financial comfort on being able to do better than people who have billions of dollars at stake.

Think of Long Term Capital Management, the U.S. hedge fund staffed by Nobel Prize winners that collapsed in 1998 after an errant wager on bond yields.

Closer to home, consider the Conference Board of Canada’s confident prediction that short-term interest rates would rise by 2.25 percentage points in the next year. That was in late 2002, when the Bank of Canada overnight rate was 2.75 per cent.

It’s two per cent now, though most economists expect an upward move in the second half of this year.

At the Bank of Nova Scotia, whose advertisements play on the short-or-long conundrum, the solution is to split the mortgage principal in two, with part paid by a five-year, fixed-rate mortgage and the rest by a five-year floating-rate mortgage.

Scotiabank’s floating rate is 75 basis points — 0.75 of a percentage point — below the prime lending rate. Prime currently is 3.75 per cent, so the floating or adjustable rate is three per cent.

The rate on a five-year fixed-rate mortgage, posted at 6.7 per cent, is negotiable but probably about 5.5 per cent.

This means that short-term interest rates would have to almost double before you’d be ahead of the game with the fixed rate.

So why not just go short?

The short answer is that you probably should — if you and your financial situation can tolerate uncertainty.

“Economically speaking, if you think like a machine and if you have a stomach for this kind of risk, taking variable rates has always been the best thing to do,” says Benjamin Tal, an economist at CIBC World Markets.

“Of course, can you sleep at night? You have to absorb fluctuations in interest rates.”

The window for low rates is closing and “many, many people have been borrowing like there’s no tomorrow,” Tal observes.

In addition to increasing debt-service costs, rising interest rates would have other effects — for instance, you might lose your job. “Higher interest rates are designed to slow down the economy,” Tal said.

“To the extent that people have been borrowing so much — and we have to remember that the current expansion in consumer spending is the most leveraged in recent history — this also means that as a society we became more sensitive to the risk of interest spikes and to the risk of any other economic shock.”

At the same time, an analysis by Tal and colleague Avery Shenfeld suggests that — because consumers are so deeply indebted — central banks will need to impose smaller rate increases than in the past to cool the economy.

“The likelihood that the Bank of Canada will raise interest rates by 200 basis points over the next two or three years probably is not very high,” said Tal.

Still, the key issue is your margin of safety.

“One has to make sure that when interest rates start rising, even by 100 basis points — and the impact will be immediate — you have to be able to absorb it.”

Tom Caldwell, chairman of Caldwell Securities Ltd., says he paid off his own mortgage before floating-rate mortgages became common but did well by always taking one-year terms.

“If I want to lock in a rate, I am asking the bank to take that interest-rate risk and, in so doing, they charge to take that risk,” Caldwell observed.

“I figured I would take on that risk, and in the 20-plus years I had a mortgage, I think I was ahead of the curve every year but one or two.”

His strategy worked during a “long-term secular decline in interest rates” while rates now are at four-decade lows, he added. But “if you take the risk, go to adjustable, you’ll probably work out all right.”

Debt Reckoning

Three questions to ask yourself before making borrowing decisions, as posed by CIBC World Markets economist Benjamin Tal:

– “If interest rates go up by 100 or 200 basis points [one or two percentage points] tomorrow, can I continue to service my debt?”

– “If tomorrow I lose my job, do I have enough degree of freedom to continue to service my obligations until I find a new one — that is, for six months or so?”

– “If tomorrow I have to pay an extra $20,000 or $25,000 on something — a health-related issue or some emergency repair on the house — can I do it without going into higher debt?”

Ran with fact box “Debt Reckoning”, which has been appended to the end of the story.

© The Vancouver Sun 2004

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