Mortgage Watch

Variable or fixed? It's the question homeowners and homebuyers ask most often and inevitably elicits an unsatisfying answer.

Whether it's worth paying the penalty to terminate a fixed-rate mortgage to obtain the lower rates available on variable-rate Canadian mortgages is a calculation that forces assumptions about future monetary policy even the Bank of Canada is hedging its bets on.

Over the past few years, the focus of monetary policy has been inflation control. What this has to do with mortgages is that the principal tool for controlling inflation is the interest rate lever. The bank has set an inflation target of two per cent and interest rates are raised or lowered to increase or reduce borrowing, which in turn stimulates or depresses demand. In this way, the bank ensures demand doesn't overwhelm the economy's capacity to satisfy it and inflation is held in check.

Since December 2007, as the economy has slid into recession, the central bank, in concert with other industrialized nations, has cut its overnight lending rate by 400 basis points to 0.5 per cent in an effort to bolster demand. Clearly, it can't go much lower.

The bank has also been trying to encourage lending by injecting liquidity into the financial system. There has been concern that this infusion of money will be inflationary, raising the threat of stagflation -- inflation with no economic growth.

However, the bank is not "printing money" to carry out this task. Rather, it is purchasing assets, such as commercial paper and bankers' acceptances, from financial institutions that have been unable to trade them because of tight credit markets and replacing them with cash or more liquid government securities.

These purchase and resale agreements are temporary and unwound after 28 days so they are, in effect, simply exchanges of assets with no increase in the monetary base.

Similarly, the federal government's infrastructure spending program should have no significant impact on inflation since government demand is replacing private sector demand. In other words, there is no increase in aggregate demand.

For inflation watchers, this should be good news. And it gets even better. In January, the bank said it expected inflation to return to the two-per-cent target in the first half of 2011 as the economy returns to its potential. It has since hinted that it might be later, sometime after mid-2011.

Variable rate mortgage rates are derived from the prime rate, which financial institutions usually, but not always, set in accordance with Bank of Canada interest rate adjustments. But negotiations on mortgage rates are getting tougher. Lenders are beginning to set variable rates at a premium over prime instead of the past practice of a discount to prime.

Fixed-rate mortgages are based on bond yields, which are market driven and largely independent of central bank moves. Higher yields increase funding costs for financial institutions which raise fixed mortgage rates in response.

As it happens, bond yields have been bumping record lows in a slumping economy, making fixed rate mortgages a better deal than they've been for decades.

So, variable or fixed? It's up to you.

That, at least, could be the takeaway from a reverse auction of mortgage securities held by the Canadian Mortgage and Housing Corp. During the weeklong auction that ended on Feb. 20, the CMHC failed to attract many sellers for its offer to buy billions in mortgages.

The Crown corporation purchased about $2.34 billion in five-year variable-rate mortgages, far short of the $7 billion it had offered to purchase. That contrasts sharply with a similar auction in January, in which CMHC had no trouble finding sellers for an offer to buy $7 billion in similar mortgages. A $5-billion auction held in October was also fully subscribed.

Why the decline in interest? It could be that the mortgage market is stabilizing, says Roger Quick, director of fixed income research at Toronto-based Scotia Capital. “This is a reasonably positive sign that Canada’s banks don’t seem to be in dire need of financing,” he says. That’s a sentiment backed up by the strengthening of the market for Canadian bank bonds, as well as a significant drop in the Canadian Dealer Offered Rate, says Quick. The CDOR is the interest rate Canadian banks charge each other for short-term loans, and it tracks both the cost of borrowing and the willingness of banks to lend money to one another.

Unlike the toxic assets clogging the balance sheets of U.S. financial institutions, most of the loans the CMHC has purchased were already guaranteed by its own mortgage insurance program. Rather than take distressed assets off banks’ balance sheets, the purchase is intended to inject liquidity into the mortgage market. “At a time of considerable uncertainty in global financial markets, this action will provide Canada’s financial institutions with significant and stable access to longer-term funding,” Flaherty said when he announced that CMHC would buy $50 billion in mortgages back in November.

He expanded the program to $75 billion in the recently passed budget. (Federal liquidity efforts go beyond mortgages; they’re trying to address the drying-up market for auto loans, as well, earmarking $12 billion to purchase securities backed by auto loans and leases. The department of finance is now asking for submissions on how to structure the purchase of those loans.)

While the U.S. government is debating whether to buy toxic mortgages at higher prices than the banks could get in the current depressed market, Ottawa is actually charging the banks a fee to take mortgages off their books. To sell mortgages to the CMHC in the most recent auction, banks had to pay an average interest rate of 76 basis points above CDOR. That’s down from an average of 112 points last month, but it still may not have been to the banks’ liking.

“It’s also about the pricing,” says Jim Murphy, president and CEO of the Canadian Association of Accredited Mortgage Professionals, which represents mortgage lenders, brokers, insurers and other industry players. “Some of the lenders may not have found the pricing of this to be very attractive.”

Despite what appears to be waning interest, Quick suggests that it’s unlikely the mortgage purchase program will disappear anytime soon, since it’s still an inexpensive way for lenders to raise money. Next month CMHC is expected to offer to buy several billion dollars in fixed-rate mortgages. If the lack of interest continues, it might be time for the government to figure out something else to do with its billions. ( article from the Canadian Business )

But the penalty charges can be prohibitive if you're in the early years of a long-term mortgage at a fixed rate.

Take Marilyn, who recently sold her house because she couldn't afford to keep it. She had a $308,000 mortgage, with three years left on a five-year term at 5.74 per cent.

She was shocked when told by the bank that the penalty cost would be about $20,000.

"That means I only pay off the bank, the real estate agent and the lawyer," she says.

"I was hoping to have enough cash in my pocket to cover my basic survival needs while searching for my next position."

Another customer, Michael, sold his condo just a year after taking out a $208,000 mortgage at 5.85 per cent.

He was charged $11,000 to break the mortgage, despite having applied for financing on another property he bought.

Both customers assumed they would pay a penalty of three months' interest. That used to be the case many years ago.

Today, most lenders charge a penalty based on the gap between current and past interest rates, the outstanding balance and the number of months left in the mortgage term.

Called the interest rate differential (or IRD), the penalty is higher now than in the past because of how far interest rates have fallen in the past six months.

There's no standard way for lenders to calculate the IRD, says Isabelle Rodrigue, acting team leader of consumer education at the Financial Consumer Agency of Canada.

"It's not an easy thing to understand and most people can't do it on their own. We advise them to shop around and talk to lenders about the benefits of renewing early."

If you're faced with a stiff penalty, you may have some leverage by negotiating with other lenders first.

"Then, go back to your current lender and say: `I'm planning to leave. Can you do something about the penalty if I stay?'" says Robert McLister, a mortgage planner.

Another tip is to make a lump-sum payment before renegotiating.

Many mortgages allow you to pay up to 20 per cent of the balance in any given year.

This lets you lower the penalty, which is calculated on the balance after you have made your prepayment.

Some mortgage brokers find that people are changing their minds about floating rate mortgages.

"There's a significant trend toward variable-rate clients moving into longer term fixed-rate loans," says Calum Ross, senior vice-president at The Mortgage Centre.

"Yes, they're paying a higher rate. But with the current economic uncertainty, they don't feel comfortable taking on additional risk."

With variable-rate mortgages at 3.3 per cent to 4 per cent and five-year closed mortgages at 4.99 per cent to 5.25 per cent, the price gap has narrowed.

In an influential study in 2001, finance professor Moshe Milevsky said that most of the time, people pay less interest over the long run by choosing a variable-rate mortgage.

But in an interview last month , he said it pays to be in a fixed-rate mortgage 10 to 12 per cent of the time – and this might be one of those times.

Not only has the premium of fixed rates over variable rates largely disappeared, but there are added risks from falling home prices, reduced availability of credit and employment instability.

An environment like we're seeing today brings into question any type of historical study, Milevsky added.

The central bank did what most private-sector economists advised it to do, cut the trend-setting overnight rate to an all-time low of 0.5 per cent and Canada's commercial banks quickly followed, cutting their prime rate by half a percentage point.

The lower prime rate, which falls to 2.50 per cent on Wednesday, will benefit some mortgage holders but will have little or no immediate impact on many corporate borrowers or credit card holders and will further reduce some interest rates paid to savers.

Scotiabank chief executive Rick Waugh said at his bank's annual meeting in Halifax that the lower interest rates is "a step forward" for the economy but insisted that the No. 1 priority is to "stabilize the world financial system"

"There's a huge amount of incentives that the governments are putting in. But unless we get our financial sector stabilized, then all these incentives will not work as well," Waugh said.

Bank of Canada governor Mark Carney said earlier that even with the central bank's overnight rate at unheard-of lows, the stimulus provided by traditional monetary policy is likely not enough help for the economy.

And Carney said the bank now sees recovery coming later than it had last projected, possibly in early 2010 instead of the third quarter of this year.

"Given the low level of the target for the overnight rate, the bank is refining the approach it would take to provide additional monetary stimulus, if required, through credit and quantitative easing," Carney wrote in a statement.

From the outset, the central bank's January economic outlook had been described by many observers as overly optimistic but Carney has said since then that the outlook acknowledged both the potential upside and downside.

A lot depended on how the situation unfolded in the global financial system, Carney said at the previous rate setting on Jan. 20, coincidentally the same day Barack Obama officially became president of the United States.

Obama and his administration has been quick to push for several massive stimulus efforts, aimed at propping up the financial sector, the automotive sector and some hard-hit American consumers, such as homeowners who are unable to afford their mortgages.

While the Canadian economy as a whole has been shrinking dramatically, as a result of lower U.S. and world demand for oil, gas, minerals and manufacturing goods, the Canadian banking system continues to be solid and the five biggest banks remain profitable.

The Bank of Canada didn't give specific examples on Tuesday on what type what specific measures are available to provide monetary stimulus to the Canadian economy, which shrank by 3.4 per cent in the October-December quarter.

BMO deputy chief economist Doug Porter said the central bank is considering a process whereby it injects money into the financial system by buying up assets such as government bonds, asset-backed commercial paper and even corporate bonds directly.

"Simply put, the bank is preparing to pull out all the stops to support the economy," Porter said.

Canada's major banks appeared ready to play ball with Carney: shortly after the announcement, Royal Bank (TSX:RY), Bank of Montreal (TSX:BMO), TD Bank (TSX:TD), CIBC (TSX:CM) and Scotiabank (TSX:BNS) announced that they would cut their prime rates by half a percentage point, in step with the central bank.

But while variable mortgage rates tied to prime are being reduced, longer-term and fixed rates have not kept pace with the central bank's moves, partly because chartered banks are reluctant to lend into a recession for fear of failures and partly because their own borrowing costs are higher than would be expected.

Still, Jim Rawson, a regional manager Toronto-based mortgage firm Invis, says the most recent cut in combination with measures in the government's January budget will increase borrowing.

"A lot of people will be interested in re-financing mortgages and it will spur a lot of first-time buyers," Rawson predicted.

The federal budget, yet to make its way through Parliament, offers $750 in tax relief for first-time home buyers while increasing the limit that can be withdrawn from RRSPs for a down payment by $5,000.

"Quite honestly, people are saying nobody is buying, but there seems to be a lot activity right now. In my region, applications doubled in January from December," Rawson said.

By most measures, Canada's credit markets are in better shape than in most industrialized countries, although still far from normal.

Carney has noted that while Canada's chartered banks continue to lend, many other financial institutions have tightened their practices or shut down altogether, reducing the availability of credit as a whole.

His reference to non-traditional monetary measures confirms that the central banker knows he has exhausted interest rate cuts as a means of stimulating lending and borrowing in the economy.

Darcy Briggs of Bissell Investment Management in Calgary said the bank could trim rates to 0.25 per cent - and likely will, as the U.S. Federal Reserve has done - but "practically, what would that do?"

There are technical reasons why a zero interest rate is impractical, economists say.

The other surprise in Tuesday's statement was that Carney appeared to back off his relatively rosy forecast for the Canadian economy, which envisioned growth returning in the third quarter of this year and rebounding to 3.8 per cent next year.

"The outlook for the global economy has continued to deteriorate since the bank's January... update, with weaker-than-expected activity in major economies," Carney said Tuesday.

"National accounts data for the fourth quarter of 2008 and other indicators of aggregate demand point to a sharper decline in Canadian economic activity and a larger output gap through the first half of 2009 than projected in January."

Carney said potential delays in stabilizing the global financial system, along with low consumer confidence and larger hit on household wealth, "could mean that the output gap will not begin to close until early 2010."

Tuesday's statement does not officially alter the forecast, but strongly implies that both this year's 1.2 per cent contraction will be worse and that the recession may last until next year.

"Reading between the lines, it's a safe assumption that their (January) forecast has already gone out the window," said Porter.

Most economic indicators have come in far weaker since January's much-criticized bank outlook, including Monday's report that the Canadian economy has shrunk by 3.4 per cent in the last quarter of 2008, far worse than the bank's negative 2.3 per cent projections.

As well, Canada lost 129,000 jobs in January, a massive amount, which Carney did not know when he made his forecast.

But possibly the most critical factor is that the global economy, especially among industrialized nations, appears to be in free-fall.

The fourth quarter saw GDP fall by 6.2 per cent in the United States, six per cent in the United Kingdom, 5.7 per cent in the Eurozone, 10.3 per cent in Mexico and a massive 12.7 per cent in Japan.

And far from stabilizing, the U.S. financial system is lurching from crisis to crisis. On Monday, the U.S. government said it was adding another $30 billion to the bail-out package for the giant insurance company American International Group Inc. after it reported a staggering US$61.7-billion in quarterly losses.

"Stabilization of the global financial system remains a precondition for the global and Canadian economic recoveries," Carney noted in his statement.