As reported by Dave Larock, May 5, 2014

“This week we dust off the old crystal ball to offer a fresh spin on the age old question of whether a fixed- or variable-rate mortgage will prove the better option over the next five years.

It has been five months since we last compared the potential costs of fixed versus variable and over that time the gap between these rates has narrowed considerably. Market five-year rates have moved from prime minus 0.55% to prime minus 0.65% while five-year fixed rates dropped from 3.35% to 2.99%.

The narrowing gap between fixed and variable rates makes it harder to decide between them. Do you take the fixed rate because it gives you cost and payment certainty for a premium of only 0.64% over the variable rate? Or do you bet that the same subdued economic forecasts that have driven fixed rates lower will keep our variable rates pinned down for years to come?

In today’s post, to help inform this decision, I will provide a rationale for a variable-rate forecast that would leave today’s variable-rate borrowers with about the same overall borrowing cost as those who opt for a five-year fixed-rate mortgage over the same period. You can then decide for yourself whether the assumptions that lead to my conclusions are too aggressive or too conservative, and thus, whether you think the variable rate risk/reward trade-off is worth it.

I would be remiss if I didn’t add the caveat that there are important qualitative factors to consider when choosing one option over the other. For example, if you’re more likely to lose sleep at night worrying about your mortgage payments increasing, you should go with a fixed rate. If you’ll lose sleep worrying about paying too much interest, a variable rate is probably the way to go. Simply put, you can’t put a price on peace of mind.

That said, there are many borrowers who are willing to live with some interest-rate uncertainty if they think that it will save them money over the next several years. It is to this group that I offer my take on how a fixed/variable break-even might unfold over the next five years.

Let’s start with the key assumptions that I used to underpin my forecast:

– The Canadian economy remains mired in a low-growth, low-inflation environment.

– Bank of Canada (BoC) Governor Poloz has recently speculated that the Bank will not raise its overnight rate, on which variable-rate mortgages are priced, until early 2016 (which I wrote about here last week).

– Even when the BoC does eventually raise its overnight rate, Governor Poloz has said that the Bank will not do this as quickly as it has in the past, and that the BoC’s neutral “equilibrium” rate will be lower than what we have seen historically (primarily due to evolving demographic trends and our record high levels of household debt).

– While it has long been accepted that the BoC will not increase its overnight rate before the U.S. Federal Reserve raises it equivalent policy rate, there is a growing consensus that the BoC may actually lag the Fed’s next rate increase for a considerable period.

Using these assumptions, my variable-rate forecast has our GDP and inflation rates moving in line with BoC Governor Poloz’s most recent estimates. This would see the Bank starting to raise its overnight rate by 0.25% in March, 2016 and then by another 0.25% in May, 2016. Once that happens, I assume that the BoC will allow some time for our economy to absorb the impact of these rate increases before tightening further.

In my latest forecast, the next round of overnight rate increases would occur in March and May, 2017, doubling the overnight rate from today’s levels. While a cumulative 1.00% increase in the overnight rate might not sound too severe, remember that Governor Poloz and others, like CIBC economist Benjamin Tal, have postulated that our record household debt levels make us much more sensitive to rate hikes. As such, it should take fewer rate increases than it has in the past for the BoC to achieve its desired level of economic tightening.

Speculating about future overnight rate increases becomes more difficult as we project further into the future, so using nothing more than a guess, I then assume that the BoC will tighten four more times in April, June, August and October of 2018. Perhaps by that point we will see the culmination of Governor Poloz’s hoped for export-led recovery and the accompanying rise in business investment that he believes is so critical to healthy Canadian economic growth.”

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