Variable rate mortgages shine

Interest rate cuts like the one announced yesterday by the U.S. Federal Reserve are providing some badly needed leverage to people renewing or taking out new mortgages.

The Fed pared half a percentage point off its benchmark interest rate yesterday, an echo of a larger cut made last week. The Bank of Canada has been trimming rates as well, and the trend is expected to continue as a result of slowing economic growth.

The upshot here for people refinancing or arranging new mortgages: Go with a variable rate. It's your best chance of out-manoeuvring the big banks as they try to squeeze extra profits from borrowers to compensate for difficulties elsewhere.

As detailed in this column last November, the big banks have kept rates on fixed-rate mortgages high, even as other rates have come down significantly. The posted five-year mortgage rate at big banks has in the past been an average of 2.5 percentage points or so higher than the five-year Government of Canada bond yield. Today, the spread has grown to almost 3.9 points.

The background here is that it's costing the banks more to raise the money they lend out to people seeking mortgages. This is fallout from the subprime mortgage mess in the United States, which has made investors demand higher returns when buying securities issued by banks. While Canadian banks have nowhere near the level of involvement in subprime mortgages of their U.S. counterparts, they have not been immune.

And so our big banks have been squeezing their customers where it hurts - on the cost of borrowing in a housing market where the national average price of a resale home hit $314,500 at the end of last year.

Mortgage broker Vince Gaetano said he talked to a lender recently who said about three-quarters of clients are going with fixed-rate mortgages today.

His reaction: bad move.

"The banks are trying to tempt a lot of consumers with upcoming renewals to lock in early," said Mr. Gaetano, a senior mortgage consultant at MonsterMortgage.ca in Toronto.

"We're telling people don't even think of locking in because prime is only going to be coming down."

You're not immune to the inflated pricing in the mortgage market if you choose a variable-rate mortgage, when you get a rate that rises and falls with your lender's prime rate. Whereas variable-rate mortgages used to come with a discount of 0.9 of a point off prime, today you're looking at 0.6 in most cases.

Still, as Mr. Gaetano points out, the trend is down for the prime rate, and that will reduce interest costs for people with variable-rate mortgages. If you're wondering how much the prime might fall, TD Economics has forecast another 0.75 of a point in cuts over the first half of 2008.

There was some talk a few weeks ago that the big banks might not adjust their prime to match every cut in the Bank of Canada's benchmark rate, which would ruin the benefit of variable-rate mortgages. The banks could in theory keep their prime rates untouched, but what a provocation this would be to customers, politicians and personal finance columnists. It wouldn't be worth it.

A novel way to deke around the big bank rate squeeze is this slick strategy suggested by Mr. Gaetano. You start by grabbing a variable-rate mortgage with a low teaser rate of, say, prime minus one percentage point for a year or prime minus 1.75 points for six months. Normally, these deals are a trap because your total interest costs are higher than you'd face if you got a plain variable-rate mortgage with a maximum discount. In this case, though, you won't keep your variable-rate mortgage until the end of its term, which is usually three to five years.

Instead, you'll wait for mortgage rates to decline over the next six months to a year and then exercise your right to convert at no cost to a fixed-rate mortgage. Borrowing costs on fixed-rate mortgages have fallen a bit this year, but the inflated spread between bond rates and mortgage rates suggests there's a lot of room for them to come down further. Another consideration is that the housing market usually picks up in the spring, prompting the banks to get more competitive on mortgage rates as they vie with each other for market share.

Here's another variable-rate strategy suggested by Mr. Gaetano. If you've got miscellaneous debts at a high interest rate, think about refinancing your mortgage in a way that consolidates all your borrowings.

It's not uncommon for people to use a home-equity line of credit for debt consolidation, and that's a smart move because your interest rate will be whatever the prime rate is. But with a variable-rate mortgage, you'll be able to borrow at prime minus a sizable discount. If you work hard to pay down your newly enlarged mortgage principal, this is the cheapest borrowing you'll ever do.

(prepared by Rob Carrick/Globe & Mail)