I have spent my entire last week anticipating what is the best decision for my clients with regards to giving them solid advice to guide their decision whether to hold or convert.
As announced throughout the media, the Bank of Canada is expected to meet tomorrow, Wednesday, July 12, 2017 at 10 am to announce whether the prime rate will indeed increase as expected.
The decision whether to jump on the emotional bandwagon in response to recent media publications for an anticipated rate hike or wait is a tough decision when considering when to wager on a large debt such as a mortgage, or even unsecured debt that is based on variable rates.
Let's go over what is important when making this decision. You must ask yourself the following questions:
Do you plan on selling your home within the next 1 to 5 years?
Do you anticipate on refinancing (increasing) your mortgage to finance personal goals, or important projects within the next 1 to 5 years?
Is your main objective to pay down your mortgage as fast as possible?
What is your tolerance to risk - are you able to sleep well at night when it comes to your finances?
Are you comfortable with your current monthly mortgage obligations?
Were you offered a cashback?
If you answered YES to the above questions, you should hold out and stay in a variable mortgage.
Why?
A mortgage is a fixed legal obligation, a contract. The terms and conditions that were agreed upon when you signed the act of hypothec and deed of loan, it clearly states the initial length of term and your ability to modify the contract he until it matures. At maturity you are open to renegotiate the terms without consequence. In a variable rate mortgage, you have the option of an open or variable closed mortgage.
A closed mortgage means that you are committed to terms and conditions until its maturity date most commonly a term of 1 to 5 years.
A variable open mortgage means your rate is based on the Prime rate determined by the Bank of Canada and may or may not have pricing built in depending on the financial institution. Most variable open mortgages hold an interest rate above prime given its ability to be modified at any given time during the contract term. Most people who have a planned date to sell their home or have the cash flow to pay their mortgage quickly; or have a matured mortgage that was not renewed into a specific product are usually those who hold a variable open mortgage. As a contract holder, you have 100% flexibility, however, any modifications may be still be subject to property evaluation fees, notary fees and potential discharge fees if you decide to modify your mortgage or transfer to another financial institution.
A variable closed mortgage means your rate is based on the Prime rate determined by the Bank of Canada and may or may not have pricing built in upon the issuance of the contract. Most variable closed mortgages hold an interest rate of prime and can also have rates below prime, this pricing discretion is based on relationship value with your financial institution. The closed term is the amount of time that the contract is fixed, normally 3 or 5 years. During this time, if you decide to sell your home, renegotiate your mortgage or desire to switch product, you usually are obliged to pay the equivalent of three months interest. In most cases three months interest can represent as low as a few hundred or for example an amount of $1500*(+) rather than five to ten or greater than twenty thousand dollars when locked in a fixed rate mortgage for a 3 or 5 year term. (* this is an example, the calculation of 3 months interest depends on the amount of the mortgage outstanding and length of amortization and interest rate). This can be advantageous when you anticipate change over the short term allowing for flexibility. Usually most variable closed mortgages have a built in clause that you may convert to a fixed rate in the event of rate hikes, often for a minimum term of an additional 3 to 5 years depending on the product and financial institution. Most variable mortgages allow for the client to make annual prepayments (lump sum payments) to their mortgage on the annual anniversary date of up to 20% of the original mortgage balance. Other institutions also offer the ability to double up on your mortgage payments in addition to the annual prepayment sporadically or recurring during the term* (*normally available up until you reach an amortization of 5 years and less). A disadvantage of the variable rate mortgage is that the payments are usually higher to compensate for any potential rate increases, and if caught in a rate hike, your amortization may be extended as a result of a rate increase if you do not increase your payments to remain on track to pay your mortgage in the time-frame expected (remaining amortization).
The following is an example of a variable rate mortgage of $250,000 at an interest rate of -0.50% below prime (currently at 2.70% as of July 11, 2017).
A fixed rate closed mortgage means your rate is fixed for the period of time in your contract ie. 1, 2, 3, 4, 5, 7, and even 10 year rates. In the majority of cases, most people opt for the 5 year term however, it is very common to see many others select 1 to 4 year terms. It is rare to choose a 7 or 10 year term unless the client must have an exceptional rate and really plans to hold the property for the long term with no plans to sell or modify the contract. Being in a fixed rate mortgage, if for whatever reason you wish to modify or break contract, you are subject to ''mortgage prepayment charge'' or ''indemnity'' a polite way of reinventing vocabulary for what we know as a penalty. The advantages however of a fixed rate mortgage are that you can have stable monthly payments for the entire term that are normally less than what you can expect for variable rate mortgages. Most clients starting off with their first mortgage who have limited cash flow, should opt for a fixed rate mortgage to ensure their budget is fixed over the term desired. If paying down your mortgage quickly is not your primary objective and 10% annual prepayment (lump sums) are satisfactory on top of your double up payments then a fixed rate if negotiated well is the best fit for you.
An option of a cashback feature, is available to both mortgage products. This is a special offer from the financial institution to provide cash or a lump sum (usually a percentage from 1 to up to 7% of your original mortgage balance) in exchange for a higher rate. A 1%-2.3% reduction in rate to achieve the best rate possible may be important to the majority of clients, usually the debt-averse, and there are others who prefer a higher interest rate in exchange for a lump sum of cash. Most clients who opt for a cashback usually have an investment property whereby the interest is tax deductible at 100% or they have debt that can easily be paid off with this sum of money that would not be included in your total mortgage balance owing. Its almost like an invisible loan that you pay for in interest payments over the term. It can also be used as a strategy to apply as a lump sum at the beginning of the mortgage term to reduce the principle balance over the the fixed 1 to 5 year term and most times it's a great winning strategy if you don't mind a larger monthly payment. If you currently have a cash back, it is important to note, that you are essentially tied to complete the signed contract to the end of term. Unless you have the intention of paying back the money received or capitalizing (adding this amount to the outstanding mortgage balance) in a refinance in order to change product or modify your mortgage. This is the biggest disadvantage of the cash back feature. This feature essentially blocks you from converting your variable rate to closed rate if you have a variable closed mortgage unless you pay back the money given to you to obtain the best current rate available.
Lastly, is your mortgage "portable" or transferable from one property to another, one who holds a closed mortgage should ask their institution if this is permitted. In this case the term, rate and remaining amortization is transferred from the sale of one property and the purchase of another, of course subject to new approvals and terms and conditions ie. Within 90 to 120 days from the time of the sale to the purchase. In this case, whether variable or fixed closed you can benefit from previous rate negotiations and potentially avoid the prepayment or indemnity charge, and transfer the cashback altogether to the new home.
Historical trend of the Prime rate
Now let's use the above information and compare to the media projections and forecasts. The following is the historical prime rate from October 2016 to July 2017. Note that the prime rate has not changed since 2015.
Forecast of the Prime rate
Now lets see the forecast also offered by Trading Economics.com:
How will a rate hike impact you ?
Based on this chart, their expectations is that the prime rate should increase to 3.7% by 2020 but should remain stable at 2.7% until Q2 of 2018. It is uncertain however what the fixed rates will be at the time of a potential rate hike in 2018. Note that the fixed rates can be modified at any time and can vary from institution to institution. (Click on below photo to go to CBC news site to view this wonderful, insightful interview or click the link in references below).
Sample rates based on the Federal charted banks
Currently the trend since the media announcements of a potential rate hike has caused the federal charted banks to increase their fixed rates on mortgages or may have potentially modified their pricing authority in response to the emotional response of clients to the news. (Click on below photo to see full article).
As the announcement is scheduled tomorrow morning, there is still time to head to your financial institution to discuss what your personal financial objectives are for your property.
Considerations
Have your representative run calculations of various scenarios to understand the risks and costs associated with future additional rate increases versus current fixed rates.
If you currently have higher interest loans or credit cards or high balances on interest only lines of credit, it would be best to consult how beneficial it would be to consolidate this while renegotiating your mortgage. The advantage of doing this exercise now is to lock in on the lowest interest rate possible before they are expected to increase indefinitely long term.
A word of advice from personal experience. Our first mortgage at staff rate in 2001 was a discounted interest rate of 6.75%. In 2014, the rates were around 3-4%. Forecast as per Trading economics predict a prime rate increase to 3.7% by 2020.
When determining whether you lock in for three or five years, in all honestly, 5 years is a really long time and a lot can happen in 5 years: you can get bored and want a change of environment, you can switch careers or lose your job, or simply just want to let go of fixed financial obligations. Currently there is a minimal difference in rate approx. 0.15% between the 3 and 5 year fixed closed rates. If you have zero intention to sell your home, you have a certain high confidence level of job security and have no upcoming projects that require financing, lock it in while you can.
If you have the potential to sell, have priority to pay down your mortgage or have the cash flow to tolerate short term fluctuations and can strategically increase your monthly payments in the event of incremental prime rate increases of 0.25% to 0.50%, then continue to remain in a variable rate and benefit from the next two years gradual transition to think about a longer term strategy come 2018. Be ready to accept the risk that fixed rates may be higher in 2018 than the current 3 to 5 fixed rates averaging as low as 2.39% to 2.54% respectively as of July 11th. Keep informed of the next interest reviews. Please find herewith the scheduled announcements for 2017:
I would love to hear your feedback or if you require a personal review of this article and its features, please reach out and I would be pleased to discuss with you.
Disclaimer
Please note that all opinions or definitions of the products mentioned in this article are based on personal knowledge and experience and rate examples as shown above are subject to authorization by your financial institution and are subject to change given the announcement on July 12, 2017. Please consult your financial advisor for a personalized review of your current contract features, terms and conditions. If you require a second opinion, it would be my pleasure to offer my personal and professional review.
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