It makes more financial sense for Canadians to lock into a longer-term fixed mortgage than one with variable rates, according to a new report released Thursday by BMO Capital Markets.
BMO chief economist Douglas Porter and senior economist Benjamin Reitzes say the improving economy and current mortgage offers tilt the balance in favour of locking in as opposed to opting for a variable rate mortgage that moves in lock-step with the prime rate.
The economists note that historically, choosing a variable mortgage rate has been more "cost-effective" than locking in on a five-year fixed rate about 85 per cent of the time since 1975. But now, they argue, fixed rate mortgages "modestly" trump variables.
Canadian mortgage holders
Fixed mortgage: 66%
Variable mortgage: 26%
Combination mortgage: 8%
Source: CAAMP/Maritz (November 2013)
"True, it may have seemed that markets and economists have played the role of The Little Boy Who Cried Wolf on higher interest rates in recent years," says their report, called "Mortgage Choices: The Fix(ed) Is In."
"But there are emerging signs that the tide is finally turning for rates, especially with the U.S. economy poised to accelerate. The bond market has sent out loud warning signals over the past year that the era of low interest rates may finally be drawing to a close."
The Bank of Canada and the U.S. Federal Reserve are both expected to begin hiking their key overnight lending rates next year. It is the overnight rate that affects the prime rate, which is the benchmark that determines variable mortgage rates.
Longer-term mortgage rates are influenced by the bond market, and the BMO economists note that bond rates have already begun to climb.
"The bond market has sent out loud warning signals over the past year that the era of low interest rates may finally be drawing to a close," they write.
"For instance, five-year Government of Canada and U.S. Treasury bond yields neared 2½-year highs early in 2014, on an improving outlook for the global economy and expectations of continued Fed tapering."
Currently, a five-year fixed mortgage from the big Canadian banks can be had for about 3.49 per cent. Some lenders, however, like the Meridian Credit Union in Ontario and some independent mortgage brokers, are offering five-year fixed mortgages as low as 2.99 per cent.
The best five-year variable rate mortgage, according to several online rate surveys, is around 2.35 per cent, depending on the province. That leaves the spread between lowest five-year fixed mortgages and the lowest five-year variable mortgages at just 0.65 percentage points. Historically, the spread between these two has been much larger.
"Even if the prime rate rises only one percentage point in 2015, and nothing more, going variable today will cost you more than a flexible five-year fixed mortgage with a fair penalty," wrote Robert McLister this week in his popular CanadianMortgageTrends.com blog.
The penalty part is key. McLister warns that locking in makes sense only if homebuyers aren't likely to want to get out their mortgage within those five years, as many do.
Prepayment penalties can amount to many thousands of dollars, even tens of thousands, for fixed mortgages, with the big banks tending to have the biggest interest rate differential penalties. Penalties for variable mortgages, on the other hand, are never more than three months interest.
Those who opt for a variable mortgage can always choose to lock into a fixed rate mortgage at any time if they see rates rising. But mortgage experts say people who do this may not get the lowest rates.
Figures from the Canadian mortgage industry in late 2013 showed that about two-thirds of homeowners with mortgages have fixed rate mortgages. But among those who had arranged financing most recently, 82 per cent had chosen to lock in.