Commentary
The Bank of Canada, as well as other central banks of Western nations, continues to raise interest rates. This program began in the summer of 2021 after it became apparent that the unprecedented expansion of the money supply due to the lockdowns has manifested in, at one point, almost double-digit inflation. The United States and Canada have, fortunately, seen inflation fall to levels of just over 4 percent. Headline inflation in Europe remains higher, with the UK posting an annual rate of 8.7 percent at the end of May.
Central bankers appear determined to maintain or even increase rates in order to slow inflation until it reaches the target of 2 percent or lower. The economic data is showing a mixed picture. Although the Conference Board’s Leading Economic Index (LEI) is flashing red, current economic indicators are showing little sign of economic weakness. Employment remains strong and GDP is still growing. Although the Federal Reserve has “paused” interest rate hikes for now, the Bank of Canada and other central bankers continue to raise rates. The predicted recession is not here, at least not yet. Until the economy confirms a downturn or inflation falls, rates will not be falling significantly.The low mortgage rates that Canadians have enjoyed over the last few years will not return for a while, at best, and will probably not be seen again for a long time. We must remind ourselves that those cheap rates were the lowest in the last few centuries. Just as people believed and feared during the 1980s that the interest rate highs of 1981 might return, borrowers might hold out the false hope that unprecedented low rates will return. They may, but historic norms have a way of returning.
In such an environment, what is a homeowner with a large mortgage to do? The future course of rates is uncertain. There is evidence indicating continued inflation and economic growth, which would mean higher rates. However, the LEI and yield curve are forecasting a recession in late 2023 or the first half of 2024. Baby boomers experienced even more uncertainty when they were in their house-buying and family-formation years. Most of them got through it fine, and most current homeowners will too. There are lessons for mortgagors to learn from the past.
In periods when interest rates are volatile and mostly rising, lock-in longer-term rates like five years make sense, even if they are higher than short-term rates. (Currently, short-term rates are actually higher than for longer periods.) This ensures that you can make your payments if rates spike significantly higher. The mortgage yield curve is inverted now, so five-year rates at just under 5 percent are still low by long term historical averages. One-year rates are around 6.2 percent. In the summer of 2021, one year rates were 2.79 percent. Homeowners facing renewal will have to pay more. It’s not a sure thing that if one took out a one-year mortgage, they could renew under 3 percent next year. In fact, if they could, then the economy would likely be in big trouble. Those unfortunate enough to lose their jobs would have trouble at any interest rate.
An individual must ask themselves an honest question. What would be more painful? Taking a five-year mortgage at about 5 percent and seeing rates fall to previous lows, or paying extra for a one-year mortgage at 6.2 percent only to see even higher rates in a year? Given the inverted yield curve, it’s doubtful if short rates will be significantly higher in a year. It really depends how much uncertainty one can live with.
Two lessons can be taken from the 1980s. Even though many of us locked in five year mortgages and then saw rates decline, few of us regretted the decision as it gave us certainty. Don’t forget that if one locks in a rate for five years during a time of inflation, their cost goes down in real terms over time.
When rates were spiking upward before 1981, those who opted for short-term rates were faced with rising costs, as many do today. The second lesson was that predicting rates for one year, let alone five years out, is difficult for professionals, so try not to worry too much. No one should be borrowing money in the first place if a 2 percent to 4 percent increase in rates would put them under serious financial pressure.
One last note. Many people may be forced or tempted to increase the average amortization of their loan to keep monthly payments the same. Caution is advised as this will reduce disposable income in the future and slow down the build up of equity. Older people save more than the young, in part because they no longer have mortgage payments.
