Gambling with mortgage rates can pay off

Kicking conventional advice in the teeth, a New York University study shows that those Canadians who gamble with mortgage rates have been the big winners. How does saving more than $20,000 in interest costs sound?

In the past few years, as Canadian mortgage interest rates flirted with 30-year lows, the sage advice from most quarters was for homebuyers and homeowners to opt for long-term, fixed-rate home loans. (The term of a mortgage is the length of time the interest rate is fixed. It also indicates when the principal balance becomes due and payable to the lender.)

The reasoning appears solid. With five-year terms in the 7 per cent to 7.5 per cent range, compared with short-term rates of 6 per cent, the slightly higher cost of locking in for five years seemed well worth it simply for peace of mind.

As well, first-time home buyers using high-ratio financing with 10 per cent or less down payment, were required to take at least a five-year term mortgage to qualify for mortgage financing. This was because, with the buyer may not be able to afford the mortgage payments on a short-term loan if the interest rate suddenly shot up.

As a result, the majority of Canadian homebuyers and those renewing their mortgage have opted for five-year or even seven-year term loans, though most keep the amortization period of the mortgage at from 20 to 25 years.

The startling new study, however, suggests that a variable rate mortgage is actually much, much cheaper in the long run. A variable rate mortgage is fully open, with a fluctuating interest rate set monthly at prevailing market rates.

''Consumers are better off financing a mortgage with short-term prime interest rates compared to long-term, fixed rates,'' according to 50-year analysis of the Canadian mortgage market undertaken by York University professor Moshe Milevsky. The study was partly funded by Manulife Financial, based in Toronto, and released in March of 2001.

The York University report shows that, during the period from 1950 to 2000, Canadians on average would have saved about $22,000 in interest costs on a $100,000 mortgage by going with short-term rather than the five-year term. (The scenario is a $100,000 mortgage with a 15-year amortization.)

In 88.6 per cent of the cases, a homeowner would have been better off borrowing at prime than with a five-year fixed term, the study discovered.

''There is no reliable predictor of where rates will go,'' the authors state, ''so consumers are better off not guessing and just going with a floating rate.''

In the past five years, the study shows, the savings would have been even higher than $22,000 if a six month or one-year mortgage rate was chosen rather than a five-year rate.

The study flies in the face of conventional advice for homebuyers in an environment of relatively low mortgage rates, in which the recommendation is to ''lock and go long on.''

But Milevsky says that, even after re-running the numbers for the past 10 years to factor in a 3/4 per cent reduction for bank discounts ''floating rate mortgages were still less expensive'' than five year terms.

So, should a Canadian consumer go only with a variable rate mortgages and gamble that mortgage interest rates will remain stable or fall? Despite the York study findings, the answer will vary with each individual. You have to understand your own risk comfort level. Could you handle higher mortgage payments if rates should suddenly rise? Will a long-term, fixed-rate mortgage allow you to sleep easier? As with many aspects of a personal real estate strategy, you have to weigh all the information and options with your own lifestyle.

By: Frank O'Brien
July 02, 2001

Copyright 2001 Inman News Features
Distributed by Inman News Features