Oil Prices and The Battle of Fixed vs Variable Mortgage

Your mortgage is up for renewal or you just bought a home and it is time to decide: fixed mortgage or variable mortgage.  Both options are at historic lows, which sounds like a broken record since the economic collapse of 2008. With 5 year fixed rates hovering around 2.89% and variable mortgages at prime less 0.6%, either option is attractive.  But how do you choose? The answer is in oil prices.

With oil prices collapsing from $140 per barrel to $45-$50 range in the last 6 months, Canada's GDP growth will slow down and there are talks of Alberta going into recession, yes the "R" word. Over the last 4 years, Alberta has been carrying the country with its economic growth. As Alberta slows down, inflation will be lower, unemployment will be higher (in Alberta, NewFoundLand and Saskatchewan).

Slower economic growth (GDP and employment) will lead to lower inflation, below 2-3% target range for the Bank of Canada which would keep prime rate at current levels.  If the economy shrinks, the Bank of Canada will cut prime rate to stimulate economic growth (as I write this post, the Bank of Canada has surprised the market by cutting the benchmark rate by 0.25%. Effective tomorrow, prime rate is 2.75%!)

Until the economy returns to "its full capacity" which the Bank of Canada is predicting to be late 2016, or later in my opinion, the benchmark rate which drives prime rate will probably not increase till then.

So, as oil prices go, so does the Canadian economy.

The Fine Print Of 2.99% Mortgage Rate

It is that time of year again....spring market. This is when the majority of real estate transactions occur and hence when the banks tend to get aggressive on mortgage pricing to gain market share. Another 2.99% offer was made by BMO which was in the headlines across various media outlets.  My objective in writing this article is to explain the fine print of BMO's mortgage. In 2014 homeowners ought to expect more transparency and explanation from their mortgage professional or bank employee.

Here are the fine print details of the 2.99% offer:

• 25 Years Maximum Amortization: It is advantageous to payoff your home early, however one size does not fit all.  If the homeowner, intends to buy an investment property, cottage or a second home in the future, the higher mortgage payment due to the lower amortization would restrict mortgage qualification. Other cases where 25 year amortization is disadvantageous are: self employed homeowner, family that's expecting a child and income will drop due to maternity leave, family that has to support a child through university, single parent,  homeowner who is looking to leave their job and start a business......
• Pre-Payment Privileges: 10%. Although the majority of lenders offer 15%-20% pre-payment privileges, I believe 10% is decent since majority of homeowners do not max out that privilege
• Increase Payment Privilege: 10%. Decent but again, not the best in the industry (15%-20%).
• Fully Closed Term: This is where BMO has their clients locked up. The homeowner can get out of the mortgage if they sell the home via bona fide sale (arms length sale) or refinances with BMO. In negotiations, if one has only option or entity to negotiate with they would not be in position to get a good deal.  The interest rate differential (IRD) for this mortgage product is punishing since it is 2% below the posted rate (4.99%) and it's equivalent to approximately 4% of the outstanding balance.

It is important for homeowners to sit with their mortgage professional and ask about the cost of getting into the mortgage (interest rate) and inquire about the costs of getting out of the mortgage (penalties, portability, restrictions).  A mortgage is one piece of the puzzle in a homeowner's financial plan and it is important to ensure the right product is chosen based on features and not just rates.