To Lock In or Not to Lock In…the interest rate question

The Financialist • Issue 99 • October 2008 
BY BRYSON MILLEY BA CFP

This is a question clients ask me regularly in relation to their mortgage. And, given recent interest rate fluctuations and home value increases, it tends to weigh heavily on many clients.

What I have found is that the right answer does not depend so much on proper predictions of interest rate movements, as on the stomach of the borrower. No, I do not mean the comparison of the ‘abs of steel’ versus the ‘spare tire’, I mean, how does it feel inside?

Generally, I would divide borrowers into two groups… those who make excess payments on their mortgage and those who worry about their payment going up. Yes, many folks have a combination of these feelings, but generally one tendency is stronger. For those who make excess payments on their mortgage, I generally suggest that they take a variable rate mortgage. The reason for this is twofold. First, variable rate mortgages will start at a lower rate. Second, because the borrower plans to make more than the minimum payment to the mortgage each month, they will have a fair amount of interest rate “wiggle” room before rate changes affect their cash flow.

Conversely, many people will find themselves constantly fearing interest rate increases if they hold a variable rate mortgage. Cash flow may be tight and/or strongly managed. As a result, a fixed rate option is generally more comfortable; they will happily pay a slightly higher mortgage payment (at least initially) in return for a happier stomach.

For example, let us assume the following for a $500,000 mortgage:

1. Variable Rate Payment

(Prime -0.7%, with prime @ 4.75%) $500,000 @ 4.05%, amortized for 25 years requires $2,653 per month

2. Fixed Rate Payment

(5 years) $500,000 @ 5.24%, amortized for 25 years requires $2,993 per month

Monthly Payment Difference: $340

Now, it is important to keep in mind that the variable rate borrower intends to make more than the minimum payment on the mortgage each month. In this situation, I typically suggest that they set the payment as if the variable rate were at 6%. Thus, the payment would look like the following:

3. Increased Variable Rate Payment

$500,000 @ 6%, amortized for 25 years requires $3,223 per month ($570 increase)

Making this adjustment has two key benefits. The first is obvious – the borrower is able to speed up the repayment schedule by $570 per month (assuming the rate remains at 4.05% in perpetuity, the mortgage would be paid off in 18 years and 4 months). But the second benefit – and the more probable outcome – is that if interest rates increase (as they do now and again), the prime rate must increase by almost 2 percentage points before the monthly payment is required to increase. This gives the borrower a fair amount of leeway and time to adjust before changes are required in their cash flow.

By contrast, watching interest rates rise and frequently changing the borrower’s cash flow requirements would cause a lot of stress for many other borrowers. This is where the fixed rate mortgage is the plan of choice. Using the above example, it comes down to $10/day – an amount that many people would pay quickly for a better night’s sleep.

Of course, all of the above is affected by many things, including family income increases and stability, and other expense obligations and their increase/decrease. But arguably the most discussed caveat is where are interest rates expected to go in the foreseeable future?

While many would argue that trying to predict interest rates is a fool’s game, we can typically get a general consensus of their direction and momentum. Inflation is a concern for the Bank of Canada and it generally combats this with increased interest rates, which are expected to come through the rest of 2008 and into 2009. However, the bigger question is, when?

Unfortunately, this is not quite so easy to predict. Right now, a lot depends on the price of oil, the relationship between the $US and the $CDN, and how affected Canada is by the global economic slowdown, none of which can be easily pegged. The Bank of Canada will be loath to increase interest rates if we are hard hit by the global slowdown, but it may be forced to if inflation continues to climb. That said, its need to increase rates will be dramatically reduced if the price of oil continues to fall (thus reducing inflation and lowering the value of the $CDN against the $US).

So what does all of this mean? My premise? In my opinion, it is much more important that you listen to your stomach when choosing whether to arrange a variable rate mortgage or a fixed rate mortgage. If the previous two paragraphs caused your stomach to turn, even the slightest, I would suggest that a fixed rate mortgage is better for you.

Ultimately, it is important that you review your borrowing tactics with your financial advisor in concert with an accredited mortgage professional to ensure that your borrowing plans are properly tailored to you.