Tuesday, July 10, 2007

Interest Rates Dilemma

Bummer about those rate changes, eh? Still wondering why it happened? OK, all kidding aside, we're glad that the BoC didn't cave to copious political pressure to leave rates as is. No recession is on the horizon currently, in fact, quite contrarily, this rate hike looks to be one of likely four to happen over the next 6 months. I'll go out on a limb and state unequivocally right here and now that I expect the BoC to increase the rate by 0.25% at every opportunity they get this year (which is 3 more after today). Look for a prime rate of 5.25% by year's end.

So what does this mean to all the house hunters out there? Ms. HHV, one of the most cautious financial managers I know, is all over variable rate mortgages these days. She loves 'em. Why you ask? Well simply put, they save you money. And a lot of it. But as all things that save you money come with, a note of caution: you gotta fit the economic fundamentals to take advantage of this.

I'm going to extensively quote an economist rather than give you a knee-jerk explanation here.
See where you fit into his advice.
  1. The first-time homebuyer and especially those who placed minimal initial down payments with high leverage ratios, are the ideal candidates for long-term fixed rate mortgages. These folks should not be taking any chances with a fluctuating interest rate. In fact, they might be hit with a double whammy if the value of their (overpriced) house declines leaving them with negative equity. To them I say,“count your blessings, don’t be greedy and lock-in at a fixed rate.”
  2. The risk-averse worrywart who is constantly looking at interest rates and wondering if ‘now’ is the time, should do what all risk-averse investors do: diversify. Indeed, there is a strong argument to be made for diversifying your mortgage debt, similar to the prudent strategy with your investment portfolio. Now, in general, diversifying your debts is a silly idea since you should put all your eggs in the one basket with the lowest interest rate. But, I do agree that split rate mortgages make some sense in today’s ultra-low environment. The ideal strategy is to partition your mortgage in two halves, one linked to a variable rate and the other closed for a longer period of time.
  3. The seasoned veteran, possibly with two stable breadwinners in the family and with a substantial amount of built-up equity in the house should still follow Shelly Short’s strategy. They can afford the risk and continue with a variable rate mortgage, making payments based on a high fixed rate schedule. This is an easy way to (think you) have your cake and eat it too. From a purely psychological point of view -- as long as you pick the payment rate to be 1% to 2% above the initial floating rate -- if and when interest rates do start to increase, it should have no noticeable impact on your monthly budget.
  4. The financially savvy arbitrageur can do even better. Most banks allow you to pre-approve a fixed rate mortgage for between 90 and 120 days. You are guaranteed the pre-approved rate regardless of what happens to mortgage rates over the next 3- 4 months. This is the closest thing to a free lunch (actually, call option on interest rates) you will ever get from a Canadian bank. If you have a floating (open) rate mortgage that allows you to pre-pay any amount anytime without penalty, then walk across the street to your bank’s competitor and ask for a pre-approval on a 5-year fixed rate mortgage. Then, keep a close eye on the Bank of Canada and the bond market. If rates increase tomorrow, exercise your free option and move your mortgage across the street, at yesterday’s rate. Otherwise, do nothing and start the process over in a few months. Understandably, the branch manager might get a bit weary of your constant requests for pre-approval…
As far as predictions go for what today's rate hike will have on the local RE market. I expect none. The resiliency of this market is ridiculous. And STUPID. Unfortunately, I think a quarter point hike is not enough to create a quick change. We've already seen a slow down in sales. This may slow them down a bit further, but I don't expect any quick changes downward on the median or average sales prices. There are still a lot of people testing the limits of this market. It's an environment that has rewarded outrageous prices for too long; knocking $80K off a sales price that's $100K over market value is no big deal right?

Until people are desperate to sell we won't see significant overall reductions. With all the unsold condos coming online in the fall, maybe we'll see something significant in that market when interest rates hit 5% in October/November?


greg said...

I would just say that every quarter point hike affects those who already have mortgages as much as it affects buyers.

And for all those homedebtors on variables, it increases the pain, and also the likelihood of people starting to lock in at higher rates - which will start to cut into general consumption and discretionary spending.

It would be interesting to see stats from mortgage brokers on how many existing clients are now starting to lock in at higher rates than they started with, and what the spread was, from original to new loans.

Every quarter point is another $1250 on a $500,000 variable rate mortgage, or approximately another $104 per month.

Depending on your mortgage, results will vary, but these amounts are noticeable amounts.

For those coming to the ends of their first 5 year terms and looking at locking in another 5 years, the rates are way above where they were 5 years ago. Considering that a lot of the people who bought 5 years ago probably couldn't afford to buy now, increasing payments by hundreds of dollars a month, on top of taxes, is going to bite hard.

These things don't happen fast, but once the tipping point is reached, look out below.

hhv said...

If we look at that scenario at peak buying years of 2005-06, then the real pain is going to start in 2010-11. Wonder what rates will be then? I'm guessing that they'll be much closer to 6.5%-7% (or the historical norm). Anyone renewing then will be in for a rude awakening. They say 70% of CDN's hold fixed rate mortgages with the majority of those being 5 year terms. So seems about right to me.

solipsist said...

Just found you. Nice blog.

As greg said about tipping points. I think that we have been at that point for a while, and that this hike, with talk of more, is Mr. Creosote's wafer thin mint.

hhv makes good points about those that were stretched thin 5 years ago, and are facing renewal at a much higher rate. Add in the HELOC's, LOC's, credit cards with low initial rates, and there is a storm brewing.

I posted vaguely about this over at vancouver (un)realestate

vg said...

did you catch the Global news last nite where they talked to the SFU economist ? He mentioned the word "bloodbath" when discussing young couples who have gotten in too deep and wracked up debt along with a rising mortgage. It is this segment that could well be the catalyst as you only need a small percentage to start a downfall if the rest are holding waiting for top dollar.

Aleks said...

"6.5%-7% (or the historical norm)"

I've been wondering, when people talk about "the historical norm" being around 7%, is that the BoC overnight rate, the major banks' advertised mortgage rate, or the actual rate you'd get on a 5 year fixed mortgage (or something else entirely)? I always look at ING and Coast Capital's rates, because they claim to offer their lowest rate without any haggling, but is that what's expected to hit 7%?

Anonymous said...

It will be the people who HAVE to sell either due to divorce, illness, moving, debt who will start the ball rolling on lower prices.

hhv said...


as I understand it (and I could be wrong) the historical mortgage rate is closer to 8.5%, so when I use the 6.5%-7% in this case, I'm talking BoC rate. Again, my assumption could completely make an a$$ of me.

vg said...


I think they mean the key rate or overnight rate which is the lower at 4.5%,the prime rate or "bank" rate as some call it is higher at 6.5 at RBC.
A couple of points higher over a couple of years if inflation keeps up would not suprise me.

greg said...

anonymous at 2:42 -

I think only one of your four factors is relevant, as I doubt there is any statistical difference in the rates of moving, divorce or illness now compared to any other time.

Debt is different - some level of equity extraction has occurred, which could not have occurred without this big run-up in prices. I would assume if you are not selling cars, trips, electronics or appliances, or second homes/condos, debt is not a good thing, if it leaves homedebtors overextended, despite their greater "paper worth".

My $.02.

hhv said...

I saw a segment on household debt vs savings on CBC last night... that ratio is at an all time low. More people are spending more than they make, and saving less than they ever have before. If you think that is sustainable and won't have far reaching economic consequences then I'd love to hear why?

Interesting anecdote... been a slurry of price reductions in condos lately in our segment... the culprits? a lot of 'em are 55+ only buildings; and I thought the boomers are coming here en mass and snapping those up?

Aleks said...

I know a fair number of people over 55, mostly my parents and their friends, and none of them have any interest in living in a condo or a 55+ complex. They already own homes and don't want to leave them, and they don't want to be around a bunch of old people because it makes them feel old. The only people I know who live in that sort of place are in their late 70s or 80s and need some level of home support. So I think it's going to be another decade before the boomers start flocking to the 55+ buildings, if they ever do.

vg said...

my inlaws are in their 80's and still dont want anything to do with these kind of places though they did sell the farm and are living in a mobile home park which is a step below those.

I can see many going from their homes to assisted living places as the new ones are very nice and if they need medical care with freedom to come and go as they please they are great but many will resist til the bitter end.The older you get the more stubborn,lol.

vg said...

Dodge says inflation going to 3%, this will not be good for all those renewals the next year. Also mentioned the expected "cooling" of the housing market. At least there is someone in authority with a brain.

greg said...

Dodge is leaving his post soon. his future earnings potential is based on his credibility in this job posting, not on being a paid shill. I give him credit for doing a pretty good job, in an environment of global credit distortions. Hopefully, the next head of the BOC will take a similar balanced approach - my hopes aren't too high, but you never know

hhv said...


i think it shows just how integrated our markets are whereby the credit expansion created by greenspan's watch in the US still managed to create the credit bubble up here despite dodge's seeming prudence on that front.

vg said...

The difference I see this time around is we had alot of US influence due the media down there which spread up here. The booms in 1980 and late 80's 90 had no where near the media attention back then. We've been bombarded with all the Flip This House/make easy money shows and the CNN Money/ CNBC talking heads crowd pumping endlessly even a year ago June when all the signs of a downtrend were clearly emerging. They ignored the numbers to the bitter end til they couldn't avoid them anymore. We are at that same stage of the cycle here and a year behind as Canada usually is.

Watch the next several months, they will be changing their tune fast by the time the Canucks drop the puck on opening night,mark my words.