We got more clues last week on where mortgage rates might be headed.
On Wednesday, the U.S. Federal Reserve boosted rates for the eighth time since 2015. More importantly, it projected they could rise another 1.25 percentage points from here.
Fed chief Jerome Powell was cautious in saying, “Even the most carefully constructed projections are highly uncertain.” But what seems quite certain is that Canadian mortgage rates will go along for at least part of the U.S. ride.
If you’re in agreement with these assumptions, it quickly becomes clear which mortgage terms are the best value. We’ll review them below.
But first, a reminder
The U.S. bond market, the world’s biggest, bets that U.S. inflation will stay low. And it better. Otherwise we can kiss 3-per-cent fixed mortgages goodbye.
But what if the market is wrong? What if traders are underestimating inflation? It happened before, in the mid-2000s, the late eighties and much of the seventies, and it will (someday) happen again.
Today, the U.S. economy is in overdrive, so conditions are ripe for higher inflation. Consumer confidence is at an 18-year high, U.S. unemployment is near an 18-year low and we’re in the longest bull market in modern history.
And then there’s that spiralling U.S. debt. If debt were a narcotic, the United States would be the world’s biggest addict. In August alone, it issued US$1-trillion of debt, the most ever on a monthly basis. Other things equal, the more the United States owes to public investors, the lower bond prices and the higher North American interest rates.
We have to remember that projections are just projections. Inflation and debt levels can and do surprise markets, meaning there is no ceiling on rates.
What the market says
The Fed, the Bank of Canada, bond traders and economists are all telling us the same thing: Rates remain on the upswing.
Consensus is that U.S. rates will leap another 1.25 per cent. Bets on bond-market derivatives imply at least three more hikes in Canada.
Bank of Canada Governor Stephen Poloz doesn’t suggest otherwise. “The bank will continue to follow a gradual approach to raising interest rates,” he said Thursday. “We know that if we move too slowly to raise interest rates, the economy could move firmly above its capacity limits and inflation could establish significant momentum. We certainly want to avoid this outcome.”
If you believe what the market and central banks are telling us and want to pick an appropriate mortgage term, there are three to watch:
You can still snatch a five-year fixed mortgage near 3 per cent. That’s right around the 10-year average and way below the long-term average. With more hikes on the radar, a five-year fixed that’s anywhere in the low threes is a gift. Just remember: Breaking up with a bank before your mortgage renews can be a wallet buster. So, if you do lock in, pick a lender with a consumer-friendly penalty.
Best five-year fixed rates: 3.19 per cent or less (default insured); 3.44 per cent or less (uninsured)
The case for much higher rates is weak. Unemployment below 4 per cent (such as they have in the United States) is historically short-lived and actually precedes rate cuts. Extraordinarily higher rates would hammer spending among rate-sensitive Canadians, depressing both the economy and interest rates. That said, if you’re still worried that the market is underestimating inflation, putting your eggs in two baskets (fixed and variable) is the answer. A hybrid mortgage, as they call it, lets you participate in future rate cuts while chopping your rate-hike exposure in half.
Best hybrid mortgage rates: 2.99 per cent or less (default insured); 3.09 per cent or less (uninsured)
Prime rate will climb again, likely this year and next. But when it comes to interest rates, what goes up, always comes down. Somewhere in the distance is a recession with lower interest rates. If we get only three or four more hikes on this side of the border, a deep discount variable rate (over five years on average) should be low enough to beat a standard five-year fixed. But you must have a competitive rate, like prime rate minus 0.90 per cent or better. Variables also have friendlier penalties – usually just three months’ interest. You can even get them with budget-friendly fixed payments that don’t increase as the prime rate climbs. But don’t go variable shopping without cash in reserve. Because if inflation does overshoot expectations, prime rate would spring higher – along with your interest costs.
Best variable rates: 2.49 per cent or less (default insured); 2.79 per cent or less (uninsured)
All other terms
Rates for short-term fixed mortgages are unappetizing at the moment. That’s largely because short-term rates have followed the Bank of Canada’s policy rate, and risen more than five-year rates. On top of that, Finance Department default insurance policies have made it less economical for lenders to raise capital for shorter terms, reducing rate competition. Today’s one- to three-year terms are almost all above 3 per cent. For that price, you might as well lock in or take your chances with a variable. Unless you’re truly in need of short-term financing, look elsewhere.
As for four-year mortgages, most are priced near five-year terms. Giving up a year of rate protection for the same price usually doesn’t make sense.
Last, but not least, are terms over five years. They’re currently too expensive relative to five-year mortgages. They also carry more penalty risk because of how long-term mortgage penalties are calculated.