Lock in your Mortgage Before Rates go Higher

Prime rates likely to stay above long-term rates

Tony Humble, Financial Post
Published: Tuesday, January 03, 2006

After a decade of enjoying falling or stable mortgage interest rates, it appears that the market has turned.

The Bank of Canada has increased its prime rate by 0.75% since September, and the banks have followed with their mortgage rates. To my mind, the time has come to seriously consider locking in to a long-term mortgage. This is the first time I have made this statement since just before the mortgage rate 1994 spike -- foreshadowed as it was by eight weeks of free-falling Canada bond prices -- so this is not a recommendation I make lightly.

Many years of rate watching has made sophisticated borrowers aware that the prime rate ---which drives variable rate mortgages -- move independently of the bond market yields, which drive longer-term mortgage rates of different terms.

The recent upsurge in the Bank of Canada prime rate, to 3.25% after years at stable low levels in the 2% range indicates that the Central Bank is justifiably concerned the economy may be overheating.

Bond yields and thus mortgage rates have stayed relatively low and stable over the past decade, as economic performance has been generally strong. However, the picture is distorted by the first signs of a rare interest rate phenomenon -- a flattening, and potentially inverted yield curve.

This is where long-term rates -- usually higher than short-term rates -- move towards equality for all terms, usually a strong market indicator of perceived economic problems ahead, and lower interest rates in general.

However, with bond yields generally rising and long-term rates edging up more slowly than short term rates, we are tempted to believe that we are at the fabled "lock in point" -- the point at which it makes sense to go long, as prime rates are likely to rise above current long-term mortgage rates and stay there.

The problem today is that there is no postwar precedent for the current set of economic factors. Baby Boomers have lived through one huge sweeping increase in mortgage rates and two peaks -- in 1982 and 1991. Each peak was characterized by an inverted yield curve and rates descended rapidly thereafter, accompanied by recession. The most recent one was designed by Bank of Canada Governor John Crow to put an end to inflation, and it succeeded dramatically, to the point where Canada became so competitive our mortgage rates for similar terms were as much as 2% lower than U.S. rates.

Now, with the inflation raising a somnolent eyelid after years of slumber, we are facing the possibility of recession again, but with rates less than 1% above all-time lows. The reason I am calling for a rate lock-in at these levels is that higher short term (floating) rates could well be accompanied by a sudden drop in housing market growth. The best protection against both these factors, in my humble opinion, would be a secure, long-term mortgage rate.

Mortgage companies such as Northwood Mortgage of Richmond Hill, Ont. are able to provide a seven-year term for as low as 5.09%, and an 18-year fixed rate for 5.59%.

With the lowest variable rates at 4.2% and rising, this differential may not last long.

The question is, will locking in this level pay off over time? If short-term rates rise to 5.5% or more over the next year, and stay high or move higher, then obviously the smart move to make would have been to go long -- at least five years -- while the going was good.

According to Northwood president Arthur Appelberg "It doesn't make a lot of sense to gamble with your family's future under current conditions. This isn't the stock market -- it's your home. "Why risk missing out on the lowest long term rate in decades for the possibility that you will gain a few dollars on going short for a few months?"

Appelberg is on the record as being one of the strongest proponents of floating rates throughout the 1990s as long-term rates continued to fall, but now he has changed his tune as he contemplates a potential upward movement in long rates.

So after 15 years it seems we are finally at that major decision point. We observe that central bank prime rates, at 3.25%, are 1% higher than historical lows of 2002 and 2004, when prime dropped to 2.25%. However, long-term rates have remained at rock bottom.

Do you believe that the economy will continue to boom? If so, your finger should be on the lock-in trigger, but ironically not because long term rates may go up dramatically, but because floating rates very well could do so, increasing your variable mortgage payment significantly.

At this time of financial reflection, think hard about going long and sleeping well.

© National Post 2006