April 28th 2010

Royal Bank has raised its mortgage rates three times in a month and other banks are following suit.

What does this mean for your mortgage?

Here’s advice for those who are taking out a mortgage or renewing in the next few months.

Q: Now that rates are rising, should I lock in for five years?

A: Mortgage rates in Canada fell to record low levels. Such low rates were unsustainable, especially now the economy is coming out of a recession.

Even with the three recent increases, RBC’s five-year rate is now 6.25 per cent, compared to 5.5 per cent a month ago. It’s not that steep a climb.

You don’t know how high rates will go, but you can measure your ability to handle higher payments. I use an acronym called IDEAS for my checklist.

Income: Is your income steady and reliable? Is there a chance you’ll be out of a job for a while? Do you earn enough to pay your variable-rate mortgage as if it were a five-year fixed mortgage? (This will offset the effect of rising rates.)

Debt: Do you have a reasonable debt-to-income ratio? Your total debt should be no more than 40 to 42 per cent of your income. Are you close to exceeding this limit if your mortgage payments go up?

Equity: Do you have enough home equity? If you have at least 15 to 20 per cent equity, you can refinance the mortgage if necessary.

Assets: Do you have an emergency fund to act as a payment buffer if needed? The ideal is to have enough, in liquid assets, to cover six months of living expenses. Do you have a line of credit as a backup source of liquidity?

Satisfaction with risk: Can you accept risk? If you already have a variable-rate mortgage, your payments have been stable or going down. Can you handle payments rising by 25 to 30 per cent or more?

Q: I’ve heard that variable-rate mortgages save money over the long term. If I can handle higher payments, should I continue to float?

A: Variable mortgage rates are still very low. The average is 2.25 per cent.

Meanwhile, the gap between fixed and variable rates is widening.

For a five-year closed mortgage, the major banks are charging 6.1 per cent. (Remember that’s a posted rate, which is often discounted when using the services of a mortgage broker.)

Interest rates would have to rise quite substantially before you’d be further ahead with a five-year rate than a variable rate.

An example of a $250,000 mortgage, amortized over 35 years. He uses a five-year fixed rate of 4.39 per cent and a variable rate of 1.70 per cent, “both readily available rates for qualified borrowers.”

If rates rise by 3.25 percentage points over the next five years, who comes out ahead?

The variable-rate borrower wins – just slightly – with a balance of $232,399.92 and an interest cost of $52,376.59 over the five-year period.

This compares to a $233,026.43 balance and $52,631.23 interest cost (about $255 more) for the fixed-rate borrower.

Keep in mind that the rate increase used in this example (3.25 percentage points) exceeds the consensus view of economists by half a percentage point.

“The prime rate would have to rise over 50 basis points more than expected – and stay there – for a fixed mortgage to come out ahead mathematically. Very few are predicting that kind of scenario over the next five years.”

Floating also gives you flexibility. You’ll have to pay a penalty to sell or refinance during the five-year term.

That penalty can add up to thousands of dollars – and eat up much of your home equity – if the lender loses money by letting you out early.

So, don’t lock in if you have any doubts about where your future will take you.