Now’s the time to get your rates fixed

One of the classic personal-finance questions that mortgage borrowers face when they renew is whether to go with a variable rate or lock in a fixed rate for five years. It turns out that financial conditions now tend to favour the choice of a five-year fixed rate mortgage to an unusual degree.

For one thing, it’s likely that longerterm interest rates, including five-year mortgage rates, have either bottomed or are close to it. Most economists forecast that longer-term rates will increase from roughly where they are now in step with the economic recovery, although they expect a gentle and gradual rise.

“We’re starting at the low point of a business cycle, meaning interest rates are at a floor,” says Beata Caranci, chief economist at TD Bank Group.

Also, while it’s normal to pay a higher rate for five-year fixed compared to variable, right now there is little rate difference between them.

“You’re paying an historically small premium for rate certainty,” says Robert McLister, founder of RateSpy.com. “There was a time not long ago when you could get a one per cent edge by going variable instead of five-year fixed and you’re not getting that right now.”

Of course, the right choice of mortgage type depends critically on personal preferences and individual circumstances. Also, rate forecasts always come with a high degree of uncertainty. But overall, “you have to say to yourself that ‘my chances of being right with the five-year fixed is probably greater than my risk of being wrong,’ ” says McLister, who is also mortgage editor at Rates.ca.

Mortgage advice is different now

Now we consider why this viewpoint is different from the standard mortgage advice that you may have heard in the past. Historical studies have shown that most of the time you would have saved money going with variable rates.

But key factors that drive that result don’t apply at the moment. Since you don’t currently pay a premium for five-year fixed, as is common during more prosperous times, variable rates don’t have the built-in head-start to saving money that they have frequently enjoyed.

In addition, as McLister points out, interest rates were until recently on a general downward trend over a period of almost 40 years. In many instances, falling variable rates would have saved you money during the term of your mortgage when fixed mortgages were left anchored higher. But both variable and five-year-fixed mortgage rates are now at ultralow levels and there isn’t much difference between them.

Competitive five-year fixed rates and variable rates are both around 1.7 to 1.8 per cent for uninsured mortgages in Ontario as of Friday, says McLister. One-year fixed mortgage rates are slightly higher, at around 1.9 per cent, he says. (Those rates are for mortgages with a minimum 20 per cent down payment, sourced directly from lenders which charge relatively moderate penalties for breaking a mortgage term early. You might find lower rates on mortgages with harsher penalties, more

restrictive terms or requiring default insurance.)

So variable rates don’t have a built-in rate advantage right now. If anything, variable rates might rise somewhat towards tthe end of a five-year mortgage term when the economy is more fully recovered, although there is little threat of much of an increase over at least the next couple of years.

Low rates in the forecast You’ve probably heard how the Bank of Canada is committed to keeping interest rates low for the foreseeable future, but understand how that works in practice.

While short-term and variable rates aren’t expected to change c much if at all in the next two years, most economists say longer-term yields are likely to gradually and moderately rise in step with the recovery.

That should result in the yield curve returning to its more normal upward slope, whereby longer-term rates are higher than short-term and variable rates.

The Bank of Canada has a stronger impact on variable aand short-term rates than long-term rates. It establishes the benchmark for variable aand short-term rates through its setting of the “overnight” interest rate (also called the ““policy” rate), which is the target rate for major financial institutions lending and borrowing between themselves for one day (that is, overnight). Variable-rate mortgages a are set in relationship to the prime lending rate, which in turn has a close relationship to the overnight rate.

Longer-term yields are determined to a large extent in the bond market and reflect the market’s assessment of factors including long-term growth and inflation prospects, and especially the interaction with U. S. and international interest rates, says Caranci. Thus longer-term rates tend to rise during periods of global economic recovery with a degree of independence from Bank of Canada actions.

Of course, the bank’s policy rate influences long-term rates. The bank also has a direct impact these days through its current massive bond-buying program known as Quantitative Easing. As a result, the Bank of Canada can be expected to help moderate and smooth out the rise in

long-term rates, but it doesn’t fully control them.

“The long term end of the yield curve is not pinned to the policy rate per se,” says Caranci. “It rises ahead of your policy rates.”

Five-year fixed mortgage rates are largely driven by the benchmark of five-year Government of Canada bond

yields. Financial institutions apply a premium to those bond rates to ensure they cover their costs and credit risks. As of Thursday, the Government of Canada five-year benchmark bond yield was 0.44 per cent, as reported by the Bank of Canada. In their October forecast, TD Bank Group economists projected that those five-year bond yields will gradually rise to 1.25 per cent by the end of 2022.

Those forecast rates two years out are still low by past norms.

“We’re so abnormal in terms of the low level of yields right now,” say Caranci.

“Even as we ‘normalize,’ it’s not normal.”