7 april 2010

Now we wonder, maybe it would be better for us to get a variable-rate mortgage, especially during the periods when rates are low. We could use saved money to make extra payments on principal. Will it be more profitable when our payments are higher than our current fixed rate?
Answer: As far as interest rates are concerned, it’s might be more profitable to choose a variable rate mortgage. This is a result of the “yield curve.” “Normally”, yield curve is positively sloped: the interest rates are lower for short-term maturities (1-2 years) and higher for longer-term maturities (5-30 years). When the economy becomes more stable, the Bank of Canada will raise short-term interest rates, and the base for variable-rate mortgages (usually the prime rate) is moved higher. It’s a sign of a “tightening” period of monetary policy (to cool the economy and reduce inflation).
The bonds tend to move according to inflationary expectations. It means that if bond investors expect inflation, they demand higher returns (i.e. interest rates) as a kind of protection from inflation. When the Bank of Canada fights inflation by raising short term interest rates, long-term rates remain stable, because long-term bond investors are content that inflation won’t grow.
Basically, while short-term interest rates may go up, they do so only until the Bank of Canada has slowed the economy enough to fight the anticipated inflation. Then, as economic growth slows, the bank starts to lower them. The yield curve will flatten for some time, but when the economy slows, short-term rates will go back down and the yield curve returns to its “normal” positive slope.
Variable-rate mortgages will move up to being almost equal to locked-in five-or 10-year rates, but later they will return to lower levels. Actually, it’s more profitable to have the variable rate mortgage. The only exception is a hyper-inflation (like in the 1980s) when short-term interest rates went to extremely high levels.
If you are planning to get a variable at prime minus, you can choose payments level a bit higher than minimum. Almost always, it will be still much lower than if you chose today’s fixed rate.  Moreover, the low interest rates can allow you to pay off large amounts of principal. Yes, the economy is strengthening and short term rates will go up a bit in the next few years, but we don’t think it will be so bad. The variable-rate mortgages still look more attractive.