February 10, 2011
Here we go, again. The economy is generating more jobs, a handful of banks raise mortgage rates and all of a sudden you’re being advised to lock-in your mortgage before the bank doors slam shut. In fact, some say you’d better hurry-up and buy a house now before mortgage rates go so high you’re locked-out of the housing market for ever.
This is not the first time that mortgage rates are on the brink of blooming only to fade a few months later. This has happened more than a handful of times in the last decade. The headlines are often the same. A month or two of increasing mortgage rates, the public is urged to act now, and then a few months later something unforeseen appears on the horizon.
The last occasion was just over a year ago. The posted 5-year mortgage rate in March, 2010 went from 4.7 per cent to 5.15 per cent in April, and then to 5.3 per cent by May. The recommendations were clear: lock-in. But then, by October they were back to 4.5 per cent. The economy sputtered, Greece and Spain hit the headlines and the rest was history.
Don’t get me wrong. Short-term interest rates are abnormally low today and the Bank of Canada has pledged to raise them eventually. But that is a far cry from advocating that you lock-in your mortgage – which is actually driven by long-term bond market rates – or heaven forbid using this as an excuse to buy a house you can’t really afford.
My main concern is about relevance and context of this advice. I call it the fallacy of “carve-out thinking.” It stems from the misguided notion that modern-day personal financial problems should be viewed and solved in isolation.
Remember that mortgage payments are just one component of your personal balance sheet. You may also have an RRSP, TFSAs and other investment accounts. You may also have a pension, cottage or rental property and a very large portfolio of debt. Every one of these holdings is sensitive to interest rates.
If long-term interest rates move up quickly and substantially then any bonds or fixed income investment you hold will fall in value – possibly by a lot. A big and sudden rise in interest rates won’t be kind to the real estate market either. There will be many spillover side effects.
Reacting to this fear by locking-in your mortgage is akin to preparing for an ice and snow storm by only salting your driveway, but forgetting to close your windows. Sure, that helps, but if you really believe a bad storm is on its way, there are many other – possibly more important—things you should be doing to prepare.
So what should you do with your mortgage? Here’s the best guidance I can offer.
1.Don’t rush into home ownership because you are convinced that mortgage rates are headed-up and you will never see 5 per cent again.
2.If you’ve just bought a home and you have a large mortgage, relative to the home’s value, I urge you to lock-in for as long as possible. You probably should not have “floated” to begin with and are now facing the probable risk that real estate prices decline and interest rates increase. Add to this the possibility of job loss, disability or other macro factors, and you are the ideal candidate for a fixed rate mortgage. The last thing you want to be doing is trying to renew your mortgage in a year or two from now, if rates increase and possibly the appraised value of your house has declined by 10 per cent or more.
3.If your mortgage payments are only a small fraction of your monthly expenses and you have built-up substantial equity in your home, and – this is key – you have a diversified portfolio of financial assets, like stocks and bond inside your RRSP and other accounts, then my advice to you is very different.
If you are concerned that interest rates are on their way up, then perhaps you should change your asset allocation and reduce the fixed income investments in your portfolio . Remember, if mortgage rates increase, this is because long-term interest rates have gone-up and the longer the duration of your bonds, the greater are your losses. I say, lighten-up on bonds. If the prognostications prove correct and rates go up, then yes you will pay more on the mortgage but you were spared the pain in your RRSP. On the other hand, if rates stay around their current levels, then you win. . Remember, locking-in today will likely involve paying more than what you are paying right now, often by 1 per cent to 2 per cent more. Think of it as insurance.
The point is to think more holistically about all the financial assets – and risk exposures—on your personal balance sheet. As for me, I have a floating rate mortgage because I can tolerate the risk and want to pay as little as possible for unnecessary insurance.
Moshe A. Milevsky is a professor at York University’s Schulich School of Business. His latest book is Pensionize Your Nest Egg.