Lest you think too many mimosas at Sunday brunch impacted our headline choices today, fear not. As long-time readers can attest, we don’t hype interest rate timing around here.
Guessing rate direction beyond the short term can be like guessing solar flare intensity. It ain’t easy. Professional economists with big fat salaries botch rate predictions for a living.
Yet, many a borrower feels they can take a variable rate to save money for a few years, and then lock in like a champ—right before rates shoot up. These folks might need a bit of introspection on their market skillsets. It’s tough to time better than Bay Street’s best.
But here’s a better question: How much does skill even matter?
Academic types believe interest rates move randomly (see research from “Fama” 1970, “Lo and MacKinley” 1999, etc.). The formal name for this is efficient market hypothesis. The theory holds that surprises routinely alter the course of interest rates, and by definition, surprises can’t be forecast without a hot tub time machine.
So why bother?
If You Want to Bother Anyhow…
Let’s suppose you’re a consistent significantly above-average bond market timer. The first thing we’d recommend is, quit your day job and become a trader.
Barring that, here’s how you’d go about timing a rate lock:
- develop a back-tested rate trading strategy that can identify medium-term (or longer) turning points in bond yields; then exploit lender mispricings (i.e., take advantage of fixed rates that haven’t increased yet)
- select the correct rate type and length for your initial term.
We won’t get into #1, as even a holy grail system that’s right the majority of the time is still wrong a lot. And 40-45% inaccuracy can hurt one’s personal finances, particularly if the borrower can’t afford to be wrong.
This article is more about helping you with the second point. That is, identifying the best term for market timing purposes.
Today there are two such terms:
#1) The 5-year Variable
Variables have key advantages:
- They let you magically convert to a fixed rate anytime without penalty (the magic usually requires a phone call to your lender or clicking a few buttons on the lender’s online portal)
- This lets eager rate timers lock into a 5-year fixed if they think rates are imminently headed higher.
- Most variables have cheap 3-months’ interest penalties
- If you want to lock in ahead of a rate spike—or reset your rate lower after falling rates—your existing lender can sometimes be stingy on the new rate they offer. A cheap penalty means you can cost-effectively tell your lender “sayonara,” and then secure a better rate at another lender.
#2) The 1-year Fixed
One-year rates have their own advantages:
- As we speak, 1-year rates are at least 24 to 30 bps cheaper than a variable if insured/insurable
- They don’t bind you to a long-term 5-year mortgage
- Most 5-year mortgages last just 3.8 years on average, given that life happens — i.e., people move, refinance or just sell and break their mortgages early.
- One-year increments let you reset every 12 months to whatever the optimal term is at the time.
- Just beware: One of the biggest beefs with one-year terms is that most (not all) lenders refuse to cover your costs when you switch into a new one-year term.
- Penalties on one-year terms can be reasonable
- Even if you want to break before 12 months, you likely won’t pay more than a 3-month interest charge in a 1-year — particularly if you choose a fair penalty lender.
Which is Better?
As we write this, 1-year fixed rates are as low as 1.29% in some provinces for insured and insurable mortgages. For those borrowers, variables will cost about $800 more per year on an average-sized ($282,000) mortgage, assuming no rate changes.
If your mortgage is uninsured, one-year terms aren’t as attractive due to their 15+ bps rate premium over variable mortgages.
One-years also let you pivot to a different term in as few as eight months. That’s because lenders let you lock in renewal rates up to four months ahead of closing.
By contrast, low-cost variables make you commit to a five-year contract. That increases the probability you’ll pay a penalty before maturity—which may be required in order to refinance, get a better rate on a port or break the mortgage outright.
With a floating rate, the variable-to-fixed conversion option gets a lot of hype. But this feature is mainly useful if you pick a lender that publishes deep-discount rates on its website. Otherwise, you’re at its mercy (rate-wise) when you ask to lock in.
That’s a serious consideration. We’ve heard from countless disappointed borrowers who were quoted mediocre “special offer rates” on conversions. Those not-so-special offers are usually a quarter-point or more above the lender’s discretionary rates for new customers. Borrowers in that position are usually better off breaking their variable, paying three months’ interest and getting a lower 5-year rate someplace else.
It’s worth noting that some variables, like HSBC’s, let you out of a 5-year term after only three years, with no penalty. That affords the flexibility of switching to a cheaper rate elsewhere if needed. As a rule of thumb, this is a useful feature if you don’t pay over ~10 bps more than the lowest otherwise comparable rate.
Just note that large banks like HSBC can charge unpleasant IRD penalties if you lock your variable into a 5-year fixed and later break that mortgage before renewal.
All in all, the unsung 1-year fixed gets our vote for rate timing in this market. It lets you:
- Save money upfront compared to a variable
- Lock into the best rate in the market in as few as 8-9 months with no penalty
- Break the contract early, when advisable, and switch to the industry’s lowest possible rate for the term you need—which could be a 3-year, 5-year, variable or whatever. And you can do that typically for a reasonable prepayment charge—just three-months’ interest most likely, especially if you pick the right lender.
One last tip: For those who are risk-averse but still want flexibility, a precious few lenders (e.g., Tangerine) let you take a 5-year fixed and then extend it anytime with no penalty. That gives you upfront peace of mind while also letting you prolong your rate protection—if you believe rates are about to soar.