There was an article published by Bloomberg on April 14th whereby the author, Sean B. Pasternak, made the point that rates are very likely at the bottom of their cycle. With many of my clients wanting a variable rate mortgage to “take advantage of the low interest rates for the next couple years,” I felt it prudent to take a step back and look at this market and rate environment in terms of historical comparison, for I don’t believe we are going to see two years of rates at this level.

In physics, when laser is pointed down towards a mirror at 30 degrees, the resulting reflection bounces back at the same angle: 30 degrees. In markets, especially financial markets this is often (but not always) the case with trends. The rapid decrease in rates in the past year is likely, but not guaranteed, to result in an equally rapid rise when the market comes out of recession. Rates have fallen from a high of around 5.90% a year ago to around 3.85% today. That is a change of 2.05% or a drop in around 35% in interest rates.

To put that in comparison, the same house with a mortgage of the same amount, (say, $500,000) would have had a payment of $2,810 last year, but can now be had with payments of only $2,160. That is a drop in the amount of $650 per month for no reason other than the economic conditions in the interest rate market.

In other words, affordability is back, but is it here to stay?

Back to my comparison to physics: the things will rebound on the same angle or trajectory as they initially arrived. With that logic, we may see a rapid increase in rates in the future as there are already signs of an economic turn around just barely underway.

My point? Taking a variable rate at Prime + 0.80% (the average market rate) results in a 5 year variable rate of 3.30% versus a fixed rate of 3.85%. This is a difference of 0.55% and most borrowers look at this number and get excited that they will be saving money. However, the last interest rate drop of 0.50% happened very fast, and could go in the opposite direction equally as fast. In fact, if inflation rears its head, we could see a move of more that 50 basis points (0.50%) occur rapidly wiping out all the savings of a variable rate mortgage, but none of the inherent risk.

Prime rate at the banks follows the Bank of Canada’s lending rate to the banks. With the benchmark rate set at 0.50% how much further can variable rates descent? I would suggest that they can’t, and that taking a variable rate in these times is akin to buying Nortel at the peak and hoping that it could go higher still. It isn’t likely.

With that in mind, why take the risk on a variable rate, hoping and praying that rates will fall, when fixed rates are at their historic lows? I have put my money where my mouth is and locked my own mortgages into fixed rates as I think these are rare times that are soon to disappear.

Some food for thought….

The article, published in its entirety is below:

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Mortgage rates in Canada, which have plunged by almost 50 percent in the last year, aren’t likely to fall further, said Phil Soper, chief executive officer of Brookfield Real Estate Services Fund.

“Certainly with the Bank of Canada’s target rate set at virtually zero, there’s very little room,” Soper said today at a conference in Toronto on Canada’s real estate market. The rate is “the lowest it’s been in anyone in this room’s lifetime.”

Rates for home loans have been dropping during the biggest financial crisis since the Great Depression, with some lenders offering mortgages approaching 4 percent, Soper said. That compares with an average posted five-year rate of 7.5 percent a year ago, according to the Bank of Canada. He added that home prices in Canada aren’t likely to rise “sharply” over the next two years.

Bank of Montreal, which sponsored the conference, lowered its rate for a five-year fixed-rate mortgage this month to 4.15 percent.

“We are approaching almost zero interest rates,” at the Bank of Canada, said John Turner, the Toronto-based bank’s director of mortgages. “The question becomes, how much upward pressure will there be as we come out of this recession?”

The Bank of Canada last month cut its benchmark lending rate to 0.5 percent, its lowest ever, and said it’s preparing to use policies beyond interest rate moves to revive an economy hit by a recession and tight credit markets. The next rate announcement is April 21.

Canadian existing home sales rose in February for the first time since September as buyers took advantage of lower mortgage rates and prices, according to the Canadian Real Estate Association’s Multiple Listing Service. Sales of existing homes rose 8.6 percent from January to 28,669 units.

Bank of Montreal senior economist Sal Guatieri predicted that Canada’s housing market will decline further this year, without the “crash” experienced in the U.S.

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This entry was posted on Wednesday, April 15th, 2009 at 2:42 pm and is filed under Home Buyer Info, Market Commentary, Potential Mortgage Pitfalls and Risks. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.