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Why Choose the Variable Rate Mortgage?

April 13th, 2010 Leave a comment Go to comments

With the Canadian economy doing surprisingly well over the past six months, many see higher interest rates from the Bank of Canada in the not so distant future, but according to a report released Thursday from CIBC’s chide economist Avery Shenfeld rates are likely to remain at a very low 2.5% through to 2011.

Historically, as far as interest rates are concerned, it is better to float your mortgage interest rate (i.e., choose a variable rate mortgage). This is a result of the “yield curve.” The “normal” yield curve is positively sloped, with interest rates lower for short-term maturities (one to two years) and higher for longer-term maturities (five to 30 years). When the economy strengthens, the Bank of Canada will raise short-term interest rates (they only have control over short-term rates) and the base for variable-rate mortgages (usually the prime rate) is moved higher. This action signals a period of “tightening” of monetary policy to cool the economy and reduces inflationary pressures.

The vehicles that determine longer-term interest rates — bonds — tend to move according to inflationary expectations: If bond investors anticipate inflation (because of economic growth), they demand higher returns (interest rates) as protection from inflation. When the Bank of Canada is perceived as “fighting” inflation by raising short term interest rates, long-term rates have a tendency, in most cases, to remain stable or improve, because long-term bond investors are content that inflation will not grow.

In essence, while short-term interest rates may go up, they do so only until the Bank of Canada has slowed the economy enough to curb anticipated inflation. Then, as economic growth slows, the bank starts to lower them. The yield curve will flatten (with higher short-term interest rates) for a time, but when the economy slows, short-term rates will go back down and the yield curve returns to its “normal” positive slope.

Over this time, variable-rate mortgages will move up to being approximately equal to locked-in five-or 10-year rates, but that’s followed by a period when they return to lower levels. More often than not, over this time, it is less costly to have held the variable rate debt. Exceptions to this situation would be times of hyper-inflation (like in the 1980s) when short-term interest rates went to extreme levels.

The economy is strengthening and short term rates will go up a bit over the next couple of years, but I don’t think it will be dramatic. The case for variable-rate mortgages remains strong.

Source: Financial Post Magazine, Tuesday April 6th & Julie Fortier, Financial Post, Thursday April 8th 2010

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