Thursday, April 9, 2009

Is it time to lock in your mortgage ?

The continued drop in rates has revived the ongoing debate all homeowners face over whether to choose a variable or fixed mortgage rate.

With interest rates so low, a lot of people are spending a whole lot of time worrying about whether or not to lock in their mortgage payments.

The rate-watching game has been a little more uncertain lately as rates have reached a point where they seem to have little room left to move.

Overall, mortgage rates have been on the decline for years now. As a result, those Canadians who opted for variable mortgages, where the mortgage rate fluctuates with any changes in prevailing interest rates, have clearly come out ahead.

Not that they're in the majority. Statistics show that only about 20% of Canadians homeowners opt for a floating rate.

The big move into variable mortgages has really only come in the past few years, with many institutions pushing floating products that allow you to lock in a rate at any time during the term of your mortgage. If you're one of these astute buyers, you'll want to hang on as long as your term allows since lenders are actually losing money on your loan right now.

But, given current bargain basement borrowing costs, will this be the way to go from here on out?

Currently, the Bank of Canada's trend-setting overnight rate is at 0.5%, and Canadian banks' prime rate is at 2.5%. Most major financial institutions are now charging good customers roughly 3.5% for a one-year closed rate and closer to 4.5% for a five-year term. (Editor's note: a licensed mortgage broker can get you 3.85% OAC)

On the variable side, you're looking at prime plus 0.8 percentage points (Editor's note: a licensed mortgage broker can get you prime plus .75%),
which today translates into 3.3% for a five-year term. (Editor's note: a licensed mortgage broker can get you 3.25% OAC)

So, if you're buying a house or simply coming up for renewal, which is it to be? Fixed or variable?

Based on several studies going back as far back as 1950, York University professor Moshe Arye Milevsky has found that homebuyers would have been better off, roughly 88 per cent of the time, financing their home with a variable rather a fixed rate mortgage.

If you don't mind a few ups and downs, the benefits of variable-rate mortgages are very compelling. But a lot has changed since those studies were first done and subsequently updated. Check out the most recent version.

For one thing, lenders have been eliminating the discounts that were once prevalent on many variable mortgages. In the past, rates were calculated as prime less a premium, often as much 0.9 percentage points. But you won't anything like that today. And, although it varies from city to city, housing prices are falling, thus raising the spectre of negative equity for some homeowners.

More importantly, if you look at rates right now, the difference between the two options just isn't that sharp. Right now, you might pay as little as 1% more to lock in a long-term rate.

Economists expect rates to remain low and even decline slightly for another year or so, then rise by as much as 3% as a recovering economy produces an increase in inflation.

This has prompted observers like Canadian Imperial Bank of Commerce's chief economist Benjamin Tal to suggest that while variable rate mortgages might still prove attractive for a bit longer, the threat of interest rates rising makes in locking in a fixed rate much more appealing than it once was.

With some variable mortgages, as rates fluctuate, so does the amount of your mortgage payments. Or, with set payment amounts, the portion of the payment that covers your mortgage principal will vary.

In a falling-rate environment, this means you'll pay down more principal and pay less interest. But if rates go up, your principal payments will shrink and it may take you longer to pay off your home. For every half point interest rate increase, the monthly payment on a typical mortgage of $200,000 jumps roughly $80 - or more than $900 a year.

The right mortgage decision is really a matter of your attitude towards risk and your need for certainty. If the prime rate does drop a bit further and you're working with a variable rate, you'll see the decrease in your mortgage rate almost immediately.

On the other hand, if you lose sleep worrying about the impact of every blip in rates on your monthly budget, then a fixed rate mortgage is for you.

Looking ahead, the odds seem to favour the latter.