Record low fixed rates and what to do about them

It’s been hot news these past few weeks. The Bank of Montreal announced a five-year fixed rate of 2.99% -- the lowest advertised rate for such a popular mortgage term by any major Canadian bank, ever. Other lenders followed suit by offering the 2.99% on four-year terms. Some lenders also lowered their fixed rates for seven-and-10-year terms.

So what's driving all these rate plunges? And should consumers lock in?

First of all, fixed rates are directionally based on bond markets and bond yields have been plunging lately, which means there is more cash available. With shaky stock markets and highly volatile commodity and currency markets, investors have been putting their money into Canada bonds, which drives up the prices and lowers the yields.

Variable mortgage rates have not been affected since they are based on the Bank of Canada (BoC) overnight lending rate, or the rate they charge banks and other lenders. Last week, the BoC’s governor Mark Carney kept the rate at 1% for the 16th straight month.

So what does this mean for variable rate mortgage holders and the estimated three million Canadians who currently have a fixed-rate mortgage? 

Well for variable rate clients, it’s hard to not to consider locking in at these low fixed rates, unless you are one of the lucky ones who were able to get a highly discounted variable rate mortgage. Those homeowners are smiling because some of them are paying anywhere from 2.1% to 2.6% and are in a good position even when Prime starts to go up, which some economists suggest will be later in 2012 or 2013.

However, lenders stopped discounting their variable rates late in 2011 so many new buyers were looking at variable rates of approximately 3%. For these mortgage holders it may make more sense to lock in to these lower fixed rates. One very attractive product is the 10-year rate currently at 3.89%.

It’s another story for fixed-rate mortgage holders. For one thing, there's the penalty you pay if you do want to make a change if you have a closed mortgage.

The cheapest fixed-rate mortgages are closed mortgages – meaning you can't escape the interest rate you agreed to pay for five years unless you pay the lender compensation for the interest it would lose by letting you switch from a higher interest rate mortgage to a lower one. 

There are two main variables that determine the prepayment penalty to get out of a fixed-rate mortgage early:

• The difference between your higher-rate mortgage and the current mortgage rate, known as the interest rate differential penalty; and
• The amount of time remaining in your mortgage's term. The longer the time, the bigger the penalty.

It’s not an amount that’s easy to figure out because each lender has its own way for calculating it. Some base their calculation on the posted rate (the current posted rate for a fixed five-year mortgage, for example, is 5.29 per cent – far above the actual 2.99 per cent lenders are now charging.) Some lenders, though, use their discounted rates to do the calculation. 

And the penalties can be huge. The only way to know for sure whether you'd be further ahead is to ask. Once you have that number it’s fairly easy for your mortgage professional to figure out whether it's worth your while to make the switch. 

The Canadian Association of Accredited Mortgage Professionals estimated recently that the 1.35 million mortgage holders who renewed their mortgages in the past year saved an average of $2,000 a year in interest costs – or $2.7 billion a year in total.

That’s something to think about.