Inflation, interest rates and 2014

The more things change, the more they stay the same. 

We’ve seen changes in mortgage rules and bank lending rules for lines of credit. We’ve seen interest rate wars among banks. The new Galaxy Android hit the market with a lot of hype. Tablets and half –tablets are getting talked up. RIM, makers of the ubiquitous Blackberry, has lost market share.  We can even pay for purchases using our Smartphones.

We get to pick the TV channels we want to watch – goodbye to bundling -- thanks to a new CRTC ruling. Life just keeps on moving forward no matter what’s happening to the economies in Canada, US and globally. 

Canada continues to reinvent itself within the context of gloomy global economies. The country remains a stable, conservative market. Canada’s annual inflation rate rose slightly to 1.5% in June, and most consumer prices remained stable. Increases in the price of passenger vehicles, electricity, food, and homeowners’ replacement costs were mostly responsible for June’s slightly higher rate, which was up three-tenths of a point from May according to Statistics Canada.

Even with the recent launch of an aggressive discounting program from auto dealers, it’s unlikely the inflation rate will come close to the 2% that Governor of the Bank of Canada (BoC) Mark Carney holds as the magic number – anything over that and Carney would consider raising interest rates.

Gasoline prices continued its downward trend in June. The overall price of consumer goods and services also fell. Food prices may change, though, since many areas of the country, as well as in the US have experienced severe drought, which may put pressure on prices.

With dismal global growth and no spectacular numbers coming out of the US, it’s safe to say, barring any major catastrophes, the inflation rate will remain low for some time despite record low interest rates designed to pump up spending. Consumers and business have hunkered down and have taken a wait and see attitude with regard to the economy, putting on hold any major purchases.

The new mortgage-lending rules are expected to help cool down the housing market and household debt growth from any moths to come.  On July 17, Carney kept the overnight rate at 1% for the 15th consecutive policy meeting dating back to September 2010.

The BoC also predicts some moderate growth and it has forecasted that the Canadian economy will strengthen by 2.5 per cent in 2014. But until then, we can expect a lackluster economy – not stagnant --but slow and steady.

Jobs an indicator of healthy economy

Canadians have heard it often during the past four years – the economy has weathered the global financial crisis and came through it with flying colours. The economy has grown and thrived without the disasters that befell other countries. The dollar is strong, the housing market hasn’t busted up despite warnings of bubbles. The GDP is growing, the rate of inflation is slow and interest rates are low. Although low rates have fuelled the economy to some extent, consumers have been reining in the pace of its debt accumulation after warnings from government of the potential dangers of  servicing high household debt.

One of the main indicators that point to a continued healthy economy is the job numbers. Without jobs, household budgets get tighter, consumer purchases slow down, manufacturers scramble to reduce inventory, which could lead to lay-offs, and bankruptcies rise. Job loss is also the leading cause of mortgage default.

Three reports this month – one on manufacturing, the other two on jobs -- show that Canada is still on track to continue its growth – albeit at a slower pace. This is happening despite the continuing crisis globally. Interstingly, Canada is benefitting from an increase in U.S consumer demand, especially for autos.

Bucking the global trend, in June, factory orders rose, according to an RBC survey. The RBC Purchasing Managers Index – considered a leading indicator of manufacturing business conditions — inched up to 54.8 last month in Canada, its highest level since last September. A figure above 50 indicates manufacturing is expanding, while a figure below 50 indicates the sector is contracting.

Then, CIBC released its Employment Quality Index, which found the Canadian economy created 155,000 new jobs in the first six months of 2012 and these were high quality jobs. Another good sign was that full-time employment rose by 1.1% during the first half of the year -- ten times faster than growth in part-time employment. And the number of jobs in high-paying sectors rose 1.6% -- more than double the pace of low-paying sectors.

Statistics Canada’s release saw an increase in jobs in the public sector – 7,300 more people were working in June, much stronger than the 5,000 number forecasted by analysts. That number is not quite as high as the number of new jobs created in previous months, but still, it's not bad.

The report also showed the public sector gained 38,900 jobs in June and full-time employment rose by more than 29,000.

While these are good numbers and show a healthy, growing economy, there have been cuts in information, culture and recreation. The agricultural sector lost 20,000 jobs and manufacturing declined by 800.

Consumer spending accounts for approximately 60% of the economy. So far, even with the anticipated softening, as longs as job numbers continue to increase, the economy will continue to weather the storms and is well-positioned to improve when global economies turn around.

Could US fallout account for recent mortgage changes?

Canadians have, on average, 15 years left on their mortgages, according to a survey released last week by BMO Bank of Montreal. And, according to a recent editorial in the Globe and Mail Canadians hold more than twice as much real estate and almost four times as much equity in it than Americans. The latest Environics Analytics WealthScapes data, found the average household net worth in Canada was $363,202 in 2011; in the U.S. it was $319,970, making the average Canadian household more than $40,000 richer than the average American household.

Yet, we keep getting dire warnings that we are financially overextending ourselves and increasing our debt load. We hear talk of housing bubbles and market crashes. And yet our dollar remains strong, our GDP has increased, our resource sector is hot and our job numbers are going up, albeit at a snail’s pace, but going up nonetheless.

Canadians have been, traditionally, more cautious than Americans. However, in recent years, we have loosened the hold on our own personal financial policies and started to spend, not unlike American households did before its economic downturn in 2008.

Canadians also learn quickly. When the messages about the increases in household debt started to appear in media reports, coupled with warnings from the government and the Bank of Canada, consumers listened and started to curb their spending and made plans to decrease their debt. However the government did not believe it was happening fast enough and implemented changes to curb spending, especially as it pertained to mortgages.  Perhaps the Minister of Finance knew something we didn’t.

Last week, CBC Canada reported the findings of Nanos Research that showed how Americans dealt with the economic downturn – it wasn’t a pretty picture. Economic numbers from the US Census Bureau show that between 2005 and 2010, American households lost 35 per cent of their average net worth. It points to two things: the decline of U.S. real estate values and changes in the stock market.

Perhaps Finance Minister Jim Flaherty’s saw this as an omen for cities such as Vancouver and Toronto, where housing bubbles could be a concern. And despite media reports questioning his reasons for making the latest round of mortgage rule changes, it might be as he says -- protecting Canadians with high debt loads against the eventual rise in interest rates.

Fixed rate mortgage accelerator strategy

By Mark Kerzner, President, TMG The Mortgage Group Canada Inc.

When I worked as a lender we saw a lot of Adjustable Rate Mortgages (ARMs) - variable rate transactions. From the early-to-mid-2000s that product seemed to be the mortgage product of choice by the brokers we worked with.

Many brokers devised strategies to demonstrate how the ARM was more advantageous to the homeowner than a standard fixed rate mortgage. The "pitch" ranged from paying less interest, to having lower payments, to aggressive principal reduction, and so on. With the benefit of hindsight, for those consumers who chose variable rate products throughout the last decade, they have, for the most part, come out well ahead.

With fixed interest rates continuing to hover at historical lows (5-year fixed rates are approximately 3.09% to 3.29% at the time of this writing) and the small spread between discounted ARMs and fixed rates right now, consumers are choosing fixed rate mortgages. The main advantage for choosing a fixed rate is that payments and rates do not change over the term of the mortgage. The most popular term is the 5-year fixed, although the 10-year fixed rate is starting to take on some momentum of its own.

A couple of years ago the Government of Canada began changing mortgage qualification criteria. One change was to use a benchmark interest rate to qualify buyers for ARMs and for fixed terms less than five years. The benchmark rate is tied closely to the bank’s posted 5-year rate, which is currently 5.24%.

The reason for this change is that ARMs and shorter term mortgages are vulnerable to higher interest rates when the mortgage renews. By building in a buffer, in this case making sure clients qualify at the higher benchmark, then at renewal, if the interest rates have increased, there is less payment shock. It also ensures that mortgage holders would be able to afford higher payments. That interest rate buffer now sits at more than 2% for clients taking out ARMS for terms less than 5 years. That means if you choose to take one of those products you have to be able to make payments on them if rates were to rise by 2%.

Once a client has decided to take a fixed term mortgage as opposed to an ARM then the next question is what term to take. Generally speaking, the longer the term you choose, the higher the interest rate. The rate for a longer fixed term may be higher but it also offers greater security against a  future rise in interest rates. My advice to all mortgage consumers today would be to set your payments as if you took the 10- year term whether or not you select that product.

If selecting a fixed rate product is similar to purchasing interest rate insurance, then purchase the insurance that is likely to pay you back in the end. If the amount of “insurance” you pay during a term results in a lower principal balance at the end of the term than that is like being paid back at the expiry of your mortgage term.

Here is an example:

Let’s take a conventional 5-year mortgage, which is under 80% loan-to-value, which also means there are no additional mortgage insurance premiums. Let’s assume a mortgage amount of $250,000 amortized over 25 years. Payments are monthly, compounded semi-annually. The seven and 10-year terms illustrated below are examples if you were to set your payments on your 5 year fixed term at the corresponding rates of each of the 7 and 10 year terms. The Total Payments and Balances at Maturity are the amounts at the end of five years.


Term        Rate        Monthly P&I       Total Payments         Balance at Maturity
5-year        3.29         $1,220.63          $73,237.80               $214,863.60
7-year        3.69         $1,273.38          $76,402.80               $211,430.47
10-year      3.89         $1,300.19          $78,011.40               $209,685.57

As illustrated above you are paying more over the life of the term but you are also accelerating the principal repayment by an even greater amount.  More aggressive strategies would have you setting your payments at the benchmark rate, which is the rate that the government is suggesting all consumers should be qualified at. If you choose, and can afford this option, you will benefit by aggressively paying down your principal during the current term. That will create numerous options for you down the road including;

1. Greatly reducing the amount of interest you pay over the life of your loan.
2. Significantly reducing the number of years it will take to repay your mortgage in full.
3. Providing you with options at (term) maturity. For example, you may decide to change the amortization to free up cash flow.

There is also another way to get the benefits without burdening your cash flow-- simply choose the accelerated bi-weekly payment options. This means you are making set payments every two weeks, which comes out to 26 payments a year.

If cash flow permits, consider combining the 10-year payment option with accelerated bi-weekly payments for added savings and balance reduction.

These options do require necessary cash flow and in many cases money may be tight right now. The beauty of a fixed rate mortgage option is that you can start this strategy at any point. If times are tight right now you can start in a year or two.

There are so many options to consider when dealing with mortgage products and there is an option that fits your individual need and situation. Talk it over with your mortgage broker.