Long Term vs ARM? What to advise our clients.

Benjamin Tal updates brokers on interest rates and stresses the importance of staying current on rapidly changing events.

Variable rate mortgages currently make up only about 20% of the Canadian market. We’ve seen a significant shift towards fixed in the past year or so, but now consumers are going back to variable because Prime is falling. I suspect this move to variable will continue for the next few months, but it will be short-lived.

If the Bank of Canada rate is going to fall by another 50 bp, it will happen within the next few months. But that doesn’t mean the 5 year rate will also fall by that much.

Remember, the bond market is already expecting this much of a cut in Prime and is discounting the 5 year rate based on that expectation. So while Prime may drop in the next few months, the 5 year rate will likely be relatively stable or slightly lower.

At some point—and it’s getting closer—we’ll see a situation in which going variable may no longer be the best approach. By cutting rates very aggressively now, the Bank of Canada is planting the seeds for inflation down the road. By the end of the year, it’s possible that we’ll see a significant correction in the bond market as the economy improves and inflation rises. If this happens, spreads will go back to normal and the 5 year rate will actually rise.

Paying close attention to developments at this point is much more critical than at any time in recent history. A few years ago we could predict that short term rates were falling, so taking a variable rate mortgage was the right thing to do. Now, we know that inflation may start rising and therefore the 5 year rate will start rising at some point. But that can happen even earlier than we expect.

Clients need to be aware that while the 5 year rate is currently attractive, it can change quickly. Rates could rise by as much as 75-100 bp in 2009. It’s very difficult to predict. But clients need to understand this risk.