5-year Prime Rate prediction

[wx_junkie]

http://i124.photobucket.com/albums/p39/wx_junkie/primerate.jpg


I initially posted this a few weeks back to help me make the decision between fixed or variable, but I see that the fixed vs. variable debate seems to be growing more and more every day.

Much of this obviously stems from what we *think* the BOC will do over the next 5 years, in order to compare side-by-side a 5-year fixed rate vs. a 5-year variable rate mortgage.

So I thought I'd open this up to a poll, to see what the consensus is based on my "personal" prediction, shown in the graphic above: Better (lower rates) or worse (higher rates), or bang on.

I also have a spreadsheet that I downloaded / modified, that can allow you to do a side-by-side comparison of a fixed and variable rate mortgage, based on what YOUR prediction is. That way, you can plug in your numbers, your prediction, and see which one will yield the lower mortgage balance after 5 years. I can't attach the file to this thread, but if you message me, I can e-mail it to you.

[wx_junkie]

Shoot.. how do you edit the poll choices? Admin??

2nd option should read: Worse than graphic (rates will go higher, or higher quicker)

[wx_junkie]

Alternatively, instead of asking me to send the spreadsheet to you, just post the following credentials of what you're considering and I'll tell you which one wins out based on the ABOVE prime rate graph.

1. Mortgage amount (including penalty, if any)
2. 5-year Fixed Rate
3. 5-year Variable Rate (Prime + ?)
4. Amortization (need this to set the payments)

[Thalo]

The graph is about bang on where I expect rates to be headed. I think Prime will go a little bit lower in the short term, to 2% (0% BOC rate, like in the U.S., or else .25% and the banks go back to pricing prime at 1.75% higher, once their cost of capital comes down) and at the very peak it probably won't go as high as 6% again. That was probably a mistake, last time around raising the overnight rates so quickly in fear of inflation, that it compounded the problems with housing on both sides of the border.

If the graph is bang on though and you consider that today you more or less have a choice between prime on a closed variable rate mortgage or 4% on a 5 year fixed, there are substantial savings to be had with a variable rate mortgage. The VIRM will be cheaper until 2012, considerably so in the short term, allowing the borrower to pay that much more towards principal, so that when higher variable rates set in after 2012, it isn't to that much of a detriment. The fixed rate mortgagor will have to renew at higher rates (probably again in the 5-5.5% range) in 2014 anyway.

I'm of course not taking for granted that rates will go exactly as I expect and still fear that inflation/stagflation could cause rates to rise sooner than we think, so I'm hedging my bets on my HELOC by fixing it in little by little. Recently I fixed in 20% of it at the lowest 5 year rate available. I'm planning to sort of ladder it out, provided I get a good enough rate. I do eventually want to have 80% of it in fixed rate terms and I don't at any time want more than a quarter of it coming due in a certain year. I'm watching 10 year rates come down now and will probably lock in another 20% at an attractive 10 year rate and then maybe look at fixing in some terms to come due in years between now and 2019. Of course the 20% left revolving allows me to pay down chunks of it faster and, on top of that, I can prepay 15% a year on the fixed terms.

[pitz]

Its really hard to tell what's going to happen in the future. 2 schools of thought, especially for residential borrowing:

a) Because North American industry is in shambles and has to be rebuilt, credit will be at a premium; that is to say, prime will be high because industry will be making absolutely enormous demands on the pool of savings.

b) The world's population is predominantly in their prime savings years, and as people start to save again, rates will be very low, as they have been in Japan for pretty much the last decade or two since the economic collapse there. The opportunity to earn a return on cash, will be fairly low due to a demographic bubble of savers.


A corrollorary to a) is that residential borrowing will be amongst the most expensive, because collateral such as housing will continue to depreciate in a rising interest rate environment, and because lenders do not want to stimulate residential real estate demand in an already over-built market.

Basically, really hard to tell the future. You can pretty much never go wrong by taking out a loan that is affordable, to buy a house that's affordable (no more than 3X income, etc., etc.), if you have a relatively stable job, with a 25% downpayment. But trying to predict rates in the future, that's just a crapshoot.

[wx_junkie]

I see a lot of votes racking up for "not as bad as indicated", but I wonder how many of the people who voted this are *hoping* this is the case, and not *expecting* this is what's going to happen. :D

[EugW]

I see a lot of votes racking up for "not as bad as indicated", but I wonder how many of the people who voted this are *hoping* this is the case, and not *expecting* this is what's going to happen. :D
That's what I'm thinking too.

IMO the graph is a reasonable estimate, but I also think there's a strong possibility that rates will go up faster/sooner.

The people who locked into variable rate mortgages when they were prime-x.xx% are very lucky. However, if you're starting now with a 5-year mortgage, no such deals exist, and the upside risk for the prime rate in the mid-term is significant IMO. Ie. Aside from maybe another 0.25%, rates can't go down any further. The only direction is flat or up, and likely the latter within a year, and quite possibly sooner.

If your graph is correct, then the taxes paid for 3.x% variable rate vs. a 4.x% 5-year fixed rate are probably in the same ballpark, give or take.

However, if your graph is too conservative, then the taxes paid for a closed variable rate mortgage could be significantly higher.

In the past, people always said that variable usually wins. And that's true. However, this is the one situation where it may just turn out to be false, as those central bank rates of 0-0.5% are unprecedented, with basically nowhere to go except up.

[onlineharvest]

I'm no expert so please be kind with your 'rebuke' if I don't make sense.

If in fact your graph is true (I would say not unlikely), then wouldn't that mean many people are in for a serious surprise when it is time to enter into a new term. Here is my thinking. We typically lock in for shorter periods (5 years is popular, with 4 and 3 year products popular months ago). One cannot deny that many people look at their payment and what they can afford. That being the case, rising rates with a potential of much lower housing prices (but even without that), monthly payments should be much higher than when people first signed on. That may affect a person's ability to make their payments. This has the potential of being even worse if they still owe a sizeable amount on a house that has lost a lot of value (assuming it gets worse also, which is not unlikely). Would not policy makers have this information in mind when determinig what to do with their interest rate? I know inflation is part of the equation as well.

Not only am I HOPING BoC rates are lower than what is pictured on your graph, I also expect it to be lower. I don't have as rosey a picture of the economy as the news world has recently and if this lull lasts years, I don't believe the rates will go up as you depicted.

Let's toss a coin and see who's right! :|

[onlineharvest]

That's what I'm thinking too.

IMO the graph is a reasonable estimate, but I also think there's a strong possibility that rates will go up faster/sooner.

The people who locked into variable rate mortgages when they were prime-x.xx% are very lucky. However, if you're starting now with a 5-year mortgage, no such deals exist, and the upside risk for the prime rate in the mid-term is significant IMO. Ie. Aside from maybe another 0.25%, rates can't go down any further. The only direction is flat or up, and likely the latter within a year, and quite possibly sooner.

If your graph is correct, then the taxes paid for 3.x% variable rate vs. a 4.x% 5-year fixed rate are probably in the same ballpark, give or take.

However, if your graph is too conservative, then the taxes paid for a closed variable rate mortgage could be significantly higher.

In the past, people always said that variable usually wins. And that's true. However, this is the one situation where it may just turn out to be false, as those central bank rates of 0-0.5% are unprecedented, with basically nowhere to go except up.

It does make a huge difference what side of the variable group you are. I was fortunate to be in the Prime minus group when prime was 4.75%. So to be honest, if the rate does go as high as the graph depicts, I've built that buffer with at least a 'worst case scenario' of what I can afford.

However, to be in the Prime plus group, with mortgage rate of 6%-7% including the "discount", that must bite into a persons affordability and/or sustainability.

[onlineharvest]

In the past, people always said that variable usually wins. And that's true. However, this is the one situation where it may just turn out to be false, as those central bank rates of 0-0.5% are unprecedented, with basically nowhere to go except up.

Assuming recent economic outlooks are incorrect (it is far worse than we expect), is it possible for rates to REMAIN as low as they are for years? I would think (and HOPE!) so.

[gomyone]

I said "better" but only by a "little" - I think the timing of your rate hikes are too soon - I don't think it'll happen until well into 2011 - the key is that while people are talking about inflation risks from all the stimulus the real battle right now is deflation (perceived and real) given the reality of a very weak economy. As long as we see tepid economic growth then there is really no reason why rates will rise by much anytime soon (ie., Japan).

[EugW]

If in fact your graph is true (I would say not unlikely), then wouldn't that mean many people are in for a serious surprise when it is time to enter into a new term. Here is my thinking. We typically lock in for shorter periods (5 years is popular, with 4 and 3 year products popular months ago). One cannot deny that many people look at their payment and what they can afford. That being the case, rising rates with a potential of much lower housing prices (but even without that), monthly payments should be much higher than when people first signed on. That may affect a person's ability to make their payments. This has the potential of being even worse if they still owe a sizeable amount on a house that has lost a lot of value (assuming it gets worse also, which is not unlikely). Would not policy makers have this information in mind when determinig what to do with their interest rate? I know inflation is part of the equation as well.
Just remember though that at end of 5 years, your principal will be that much lower. Some might have to amortize again for a long period to compensate for higher rates, but that mortgage should still be relatively affordable.

Also remember, that the curve should eventually level out. If the prime rate is around 6% in 2014, then I think that depending on what the forecasts are sounding like, it may be reasonable to get a variable rate mortgage at that time. At 6%, there is strong chance that the prime rate will go down again. At 2.5% like it is now, there is very little chance that the prime rate will go down significantly (aside from that 0.25% drop on April 21), because there's very little room to maneuver. The average posted 5-year fixed rate in the last 10 years is around 7%, with a peak of 8.75%. The average prime rate was lower obviously. So, going with variable when rates are that high makes sense from a probabilities point of view, even if nothing is guaranteed.

Some people may argue that perhaps we should be thinking about 10-year fixed rates. Actually, 10-year fixed rates are quite affordable these days at 5.25%. However, the rate premium is significant, and therefore any risk reduction from locking-in is lost from the much higher rate. Furthermore, I'd be surprised to see 80s type 18% interest rates or whatever, so I'm willing to chance "just" a 5-year lock-in given historical rates.

Thus, in my humble opinion, a 5-year fixed at around 4% makes a heluvalot of sense. With variable rates, if you have an existing prime-x.xx% rate then stick with it. However, if you're getting a new mortgage today, then you're stuck with prime+x.xx% with a spectre of potentially increasing rates, and I think it's more risky now as compared to previous years to go with variable unless you have a lot of cushion in your finances.

Assuming recent economic outlooks are incorrect (it is far worse than we expect), is it possible for rates to REMAIN as low as they are for years? I would think (and HOPE!) so.
Anything's possible. I just don't think it's probable.

However, I have no crystal ball of course.

[Bullseye]

If you think rates will be much higher in 5 years, and that a fixed mortgage is the way to go, you are essentially betting that the highly skilled economists and analysts at the big banks, and traders in the bond markets, are wrong.

The banks are not stupid, they wouldn't give you a fixed rate mortgage at a rate that they think will lose them money over that period. They prognosticate where rates are heading, they look to the bond market to see how much it will cost to loan you that money over that period, and then they set their fixed rates accordingly. If they are willing to give you a 5 year at 4.25%, it's because they believe rates will be low for the next 5 years, or at least low enough for them to make money on the spread.

[pitz]

If you think rates will be much higher in 5 years, and that a fixed mortgage is the way to go, you are essentially betting that the highly skilled economists and analysts at the big banks, and traders in the bond markets, are wrong.


Banks, roughly speaking, earn a spread regardless of whether they set you up with an overnight floating loan, or a 5-year or 10-year loan. Their business, generally speaking, is not to speculate on interest rate movements, but rather, to collect the spread between their cost of funding, and the return on the asset they're investing in, the mortgage.

Bond traders don't have that much influence either. Think of bond traders like firemen with a fixed supply of water to fight a fire. Bond traders seek to optimize where the water goes, in order to earn the best return, but they do not control the amount of water available. The supply of savings is determined by economic conditions, and not by bond traders, and hence, those bond traders can only influence spreads, not underlying interest rates.


The banks are not stupid, they wouldn't give you a fixed rate mortgage at a rate that they think will lose them money over that period. They


Banks don't care because they match assets to liabilities, and try to, as much as possible, avoid maturity transformation. If you take out a $200k 5-year loan against your shiny new house, the bank goes out and sells $200k worth of 5-year GICs at an interest rate that is somewhat below what you pay on the loan, and pockets the difference.



prognosticate where rates are heading, they look to the bond market to see how much it will cost to loan you that money over that period, and then they set their fixed rates accordingly. If they are willing to give you a 5 year at 4.25%, it's because they believe rates will be low for the next 5 years, or at least low enough for them to make money on the spread.

I think you're really reading too much into the fixed/variable issue. Your banker really doesn't care which one you take, because they're generally not betting against you on interest rates, nor are they engaged in maturity transformation to any significant extent. That is what makes Canada's banking system very unique compared to the USA -- loans at Canadian banks are very tightly matched against funding sources, whereas, in the USA, overnight deposits are often used to fund 30-year mortgages, with completely and predictably disasterous results.

In finance, this issue is known as the 'duration gap' in a portfolio.

[EugW]

If you think rates will be much higher in 5 years, and that a fixed mortgage is the way to go, you are essentially betting that the highly skilled economists and analysts at the big banks, and traders in the bond markets, are wrong.
Heh. Funny you should mention that, given the markets.

The banks are not stupid, they wouldn't give you a fixed rate mortgage at a rate that they think will lose them money over that period. They prognosticate where rates are heading, they look to the bond market to see how much it will cost to loan you that money over that period, and then they set their fixed rates accordingly. If they are willing to give you a 5 year at 4.25%, it's because they believe rates will be low for the next 5 years, or at least low enough for them to make money on the spread.
Actually, I still think that variable rate mortgages may save money in a five year term starting now. However, I also think that the chance of that is much less than it used to be. ie. A fixed rate 5-year mortgage in March 2009 makes more sense than it used to. Whereas in the past a variable rate mortgage would save money 9 times out of 10, I don't that applies here, because the unprecedented numbers at this time. And since you like to mention analysts, several are saying (http://www.desjardins.com/en/a_propos/etudes_economiques/actualites/point_vue_economique/pv90304a.pdf) the same thing.

All mortgage borrowers are facing an important decision: the choice between a fixed rate mortgage and a variable rate
mortgage. Many experts have looked at the question in recent decades. Their studies have concluded (unanimously,
to our knowledge) that a variable or short-term mortgage is superior, financially speaking.

However, the Canadian mortgage market has undergone some changes in the past few months. The financial crisis has
driven financial institutions’ financing costs up, thus increasing the premiums demanded on the loans they make.
Variable rate mortgages have been particularly affected. We have therefore re-examined the question by comparing the
interest costs for two mortgages, a fixed rate mortgage and a variable rate mortgage, based on a variety of scenarios for
interest rate.

Our calculations confirm that things have changed. In fact, according to what we believe to be the most likely scenarios,
fixed rate mortgages currently appear to be the least costly. However, this result depends on some assumptions. We
cannot assert that the fixed rate mortgage is best for every household. We can, however, conclude that, in the new
financial context, we must drop the time-tested assertion that a variable rate mortgage is always the best choice.

[EugW]

P.S. That Desjardins study (http://www.desjardins.com/en/a_propos/etudes_economiques/actualites/point_vue_economique/pv90304a.pdf) believes the BoC rate will go up to around 5% in 2014, which means that variable rates might approach 8%.

That might be a bit high, so take the study with a large dose of salt. Still, it does show the risk inherent in locking into a variable rate closed mortgage now, as we all expect such rates to head upwards (after the April decrease of 0.25%).

It will be interesting to see where the rate is in 2011, since that's when this study suggests variable rates will go higher than what fixed rates are today.

[DrXenon]

Here is an article from the Wall Street Journal that some may be interested in reading. Me, I remember the early 80s and I'm probably going to take the current 5.25% 10-year offer from TD or BNS.

http://online.wsj.com/article/SB123836516806167317.html

[EugW]

Here is an article from the Wall Street Journal that some may be interested in reading. Me, I remember the early 80s and I'm probably going to take the current 5.25% 10-year offer from TD or BNS.

http://online.wsj.com/article/SB123836516806167317.html
It depends on your risk tolerance, your current finances, and what your finances will be in 2014.

If the 5-year fixed rate goes up to 10% or higher in 2014, that would be a major disappointment, and I might kick myself for not locking in to a 10-year 5.25% agreement. However, I'd be surprised if it went that high, and the money saved from now to 2014 will be used to pay down principal. By the time 2014 rolls around, assuming I still have a job then I will be easily able to handle a 10% interest rate on the lowered principal even if I don't get any pay raises.

Note though that's because I already have significant equity in my home. My current monthly payments mostly pay down the principal. Interest represents the minority component of my monthly payments, so the reduction in my principal will be significant by the time 2014 rolls around.

This is not true for people with 35-year amortization periods if they don't make significant lump sum prepayments. By the time 2014 rolls around, very little of the principal will have been paid, and they'll be in very big trouble if rates are 10%.

For example, let's say someone has a $300000 mortgage amortized over 35 years, on a 5-year term at 4.25%. Monthly payments are $1366.90 (http://www.bankrate.com/can/mortgage-calculator.asp?unroundedPayment=1366.8953938702537&loanAmount=300000.00&nrOfYears=35&nrOfMonths=420&interestRate=4.25&startMonth=2&startDay=28&startYear=2009&monthlyPayment=1366.90&showAmort=Show%2FRecalculate+Amortization+Table&monthlyAdditional=0&yearlyAdditional=0&yearlyAdditionalMonth=2&oneAdditional=0&oneAdditionalMonth=2&oneAdditionalYear=2009&paidOffDate=Mar+28%2C+2044). At the end of 5 years and $82000 worth of payments, the mortgage principal is still $279090.65.

Trying to renew that at the end of 5 years at 10% will be a major problem. At 10% interest and another 35 year amortization period, monthly payments would be $2356.17 (http://www.bankrate.com/can/mortgage-calculator.asp?unroundedPayment=2356.170485767751&loanAmount=279090.65&nrOfYears=35&nrOfMonths=420&interestRate=10.00&startMonth=2&startDay=28&startYear=2009&monthlyPayment=2356.17&showAmort=Show%2FRecalculate+Amortization+Table&monthlyAdditional=0&yearlyAdditional=0&yearlyAdditionalMonth=2&oneAdditional=0&oneAdditionalMonth=2&oneAdditionalYear=2009&paidOffDate=Mar+28%2C+2044).

ie. Monthly payments would go up by almost $1000. Ouch!

However, take the example of say someone with a $150000 mortgage amortized over 10 years, with a 5-year fixed 4.25% rate. Monthly payments are $1533.90 (http://www.bankrate.com/can/mortgage-calculator.asp?unroundedPayment=1533.8971850441235&loanAmount=150000.00&nrOfYears=10&nrOfMonths=120&interestRate=4.25&startMonth=2&startDay=28&startYear=2009&monthlyPayment=1533.90&showAmort=Show%2FRecalculate+Amortization+Table&monthlyAdditional=0&yearlyAdditional=0&yearlyAdditionalMonth=2&oneAdditional=0&oneAdditionalMonth=2&oneAdditionalYear=2009&paidOffDate=Mar+28%2C+2019). At the end of 5 years, the mortgage principal is only $82856.34.

If in 2014 that person renewed at 10% for another 5-year term amortized again over 10 years with a principal of $82856.34, the monthly payments would actually go down to 1085.70 (http://www.bankrate.com/can/mortgage-calculator.asp?unroundedPayment=1085.6970664580997&loanAmount=82856.34&nrOfYears=10&nrOfMonths=120&interestRate=10.00&startMonth=2&startDay=28&startYear=2009&monthlyPayment=1085.70&monthlyAdditional=0&yearlyAdditional=0&yearlyAdditionalMonth=2&oneAdditional=0&oneAdditionalMonth=2&oneAdditionalYear=2009&paidOffDate=Mar+28%2C+2019). The person could even reduce the amortization to 6 years, to get about the same $1500+ monthly payment.

Basically what I'm saying is that a 10% rate in 2014 is something that should scare a lot of people, but its significance will be much more for some than others. Everyone should go through all the calculations before choosing.