I was recently asked by a client whether they should re-finance their mortgage, and if so, how should they do it.

Since there is no way to predict the future, that is a difficult question to answer.  However, the most reasonable way to approach that question is to look at it from the perspective of risk.  A simple search on the internet for mortgage rates reveals that, if an individual were to choose a floating rate right now, they would only have to pay approximately 2% interest.  That means only $2,000 interest annually per $100,000 borrowed.  Not bad.  However, the real problem comes if/when interest rates go up.

The general answer (likely denial) is that the individual will switch to fixed when rates start to rise.  This is a difficult game to play, and it involves predicting the future.  What makes it even more difficult, is that it involves not only predicting the future of interest rates, but being able to do so better than the banks.  The problem with the timing of “the switch” is that the banks set interest rates partially at their discretion.  So, when interest rates are set to rise, they are most likely to raise the long term rates first (making a long term mortgage seem less appealing), and then raise the short term rates later.  This pattern means that consumers will stay in their floating rate too long, and switch too late, once the lenders have had the chance to adjust the longer term rates in their favour.

Worse, if the homeowner is making their buying decision (and affordability) based on low interest rates, it will be unlikely that a higher interest rate later will be work.  This would be like going to a tailor and asking them to give you a pair of dress pants that do not fit because you plan to lose weight before you wear them.  That is not likely, as time tends to deliver weight gain, not weight loss (sadly).  In this market, time is most certain to deliver higher interest rates, not lower (sadly).  Locking in now might appear unappealing, might mean a smaller house and/or higher payments, but might just be the most prudent decision in the long run.

So, what is reasonable?  Right now (Weds Aug 4), a google search tells us that the 10 year rate is approximately 5.0% to 6.5%.  That is an unbelievably good rate.  If you are new to mortgages, find someone who lived through 12-15% long term rates in the early 1980’s to figure out how good that is.  My advice is to make as much of the mortgage fixed rate as possible, and for as long as possible.  Here are some tips:

• If you think you can aggressively pay down the mortgage, then figure out how long it will take you to pay of the mortgage and match the term to that timeline.
• If you feel your income will increase in the future and you will be able to pay down more aggressively than a fixed rate term will allow, then take a potion of the mortgage fixed, and take a portion of the mortgage floating.
• If you are convinced that rates are going to remain low for a while, then take a look at some recent history:
  • The Bank of Canada site gives loads of information about interest rates:
  • if you could negotiate a 5.5% 10-year rate, this is lower than the average 1-year rate for the last decade – the decade with some of the lowest interest rates in history
  • As recently as 2007, the prime lending rate was as high as 6.5% dropping to 2.5% in as little as 14 months.  The reverse could also happen (and has!).

Could you afford to pay three times as much interest on your mortgage within the next 2 years?

One final point – the main issue here is not that the “average” floating rate over the next 10 years will be higher than 5the fixed rate is now.  What is conceivable is that, in that time, short term rates could rise for a period that makes it unaffordable to finance your home.  You don’t have the advantage of the law of averages: as soon as your home becomes unaffordable, you may be forced to make some tough decisions (either sell, or refinance and begin a vicious circle, now with expensive long-term debt).

So, paying a higher fixed rate right now is difficult to swallow, because rates have just been so intoxicatingly low, and it appears that taking a 5.5% mortgage will cost you something, at least in the short term.  However, it is reasonable that you will not be able to make “the switch” on time, and you might get stuck scrambling to get into a fixed rate mortgage at much higher than 5%.  Remember that mortgage debt tends to take 10-20 years to pay off, if not more.  A long-term approach (with some historical context) makes some sense at this point.