The Disappearing Variable Rate Discount

The days of deeply discounted variable rates seems to have disappeared. Over the past month lenders have been slowly reducing their discounts from as low as P-.80% to now prime and prime plus. There are still a few holdouts -- lenders who most likely see an opportunity for some quick deals -- but it probably won’t be long until those gaps are totally closed.

Fixed rates, on the other hand, can be had for as low at 3.39% on a 5-year term (at the time of this writing). When spreads are this tight, it’s no wonder that industry insiders are reconsidering all the research suggesting that variable rates are the way to go.

Variable rates have been the most popular choice among homeowners between the ages of 35 and 44 according to a report from Canadian Association of Accredited Mortgage Professional (CAAMP). While there is always a risk that interest rates will fluctuate, there are other factors to consider. The greatest advantage is the long-term savings on interest costs. Research has shown that people have saved money on variable-rate mortgages more than 80 per cent of the time.

Online mortgage news source Canadian Mortgage Trends recently interviewed Benjamin Reitzes, Senior Economist for BMO capital Markets who said borrowers won't see the same advantage to variable rates as they have in the past 25 years because the prime rate, which is sitting at 1%, can’t drop 1% -- there is room for a slight cut, which some economists say may happen in 2012, but the stronger likelihood is that rates will start to slowly climb in the latter part of next year.

Much of the reasoning for preferring variable over fixed is, of course, the interest savings. When we take a look at the spreads between fixed and variable rates between 1970 and 1995, there is a difference of 126 basis points compared to the average difference today of 50 basis points. That translates into a lot of savings.

Although the spreads have been reduced and discounting is disappearing, what hasn’t changed is a home owner’s decision-making process. When variable rates were historically low and fixed rates were substantially higher, many home buyers opted for fixed because they knew exactly how much principal and interest they paid on each regular mortgage payment throughout the term. And for some, having that peace of mind is the determining factor.  

So the question of whether going fixed or variable still comes down to what makes a home owner comfortable. However, it’s really a win/win for home owners -- with fixed rates so low, and with the prime rate increasing some time in 2012, the fixed rate may indeed outperform the variable rate, but even if it doesn’t, the extra interest costs on fixed rates will be far less than in past years. 

Global economic crisis may have a silver lining in Canada

The ongoing financial woes in the US and in countries in Europe are one of the contributing factors to Canada's stable housing market and historically low interest rates, and these rates will continue right into mid-to late 2012.

The variable rate, which is based on the Bank of Canada's Prime rate is sitting at 3% and is likely to stay there right up until mid-to-late 2012. The main reason for this is the very slow economy in the US. The Federal Reserve there has already announced that their prime interest rate will not increase until 2013, hoping that it will create a more fertile ground for economic growth. By keeping the rates low, they hope to stimulate borrowing from businesses and consumers. Because the US is a major trading partner, it forces us to keep our rates low to keep our economy growing while we wait for the US and for Europe to catch up.

Fixed rates will start moving up earlier than the variable rate but without major jumps. Benjamin Tal, deputy chief economist for CIBC said in an exclusive interview with TMG The Mortgage Group that fixed rates, which depend on bond markets, will remain relatively stable, with small increases, over the next six to eight months.

"It is interesting that, here in Canada, when we believe there will be a slowdown, something happens in the world that helps us and makes our economy stronger," he said. "And because there is uncertainty in world markets, the Bank of Canada won't raise rates until those markets stabilize, which will take some time."

Currently, the Canadian housing market and the economy is stable and balanced. Consumers have been listening - they have slowed the pace of their borrowing and have been working on paying off their debts. It is, indeed, an ideal time, when rates are low, to do that. Tal cautions, however, that low interest rates may fuel an increase in borrowing, which has not happened yet, and this could be worrisome in the long-term.

"Credit is not a bad thing - it is the electricity of the economy," he said. "We want banks and consumers to be responsible with their borrowing."

Low interest rates are attractive but borrowing like there's no tomorrow is dangerous. Eventually those rates will go up and if you're stuck with large lines of credit it may be more difficult to pay them off and could burden the household budget.

There is a window of opportunity now to reduce debt loads and pay them outright. If you would like to discuss your options, please contact me.

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