Fixed vs. variable: Why this week’s BoC rate hike shouldn’t change your mortgage strategy.

General Simon Wong 25 Oct

Some variable-rate mortgagors are feeling a bead of sweat after today’s Bank of Canada quarter-point rate hike. The bank’s communications today suggest it’s dead set on “normalizing” rates. Translation: Today is not the last time prime increases in this rate cycle. Shrewd borrowers have chosen variable-rate mortgages for years. After all, that’s what the research supports.

You don’t throw out a good strategy because of five rate hikes in 15 months. Variable rates have exceeded five-year fixed rates in the past, but over any historical five-year period they’ve won out “about 88 per cent of the time,” says Moshe Milevsky, author of Canada’s most cited mortgage research.

And my own simulations confirm it. The best variable rates have beaten the best five-year fixed rates throughout every rate spike since the dawn of modern monetary policy (1991). That’s not a definitive sample size, especially given that rates have been downtrending for decades. But you can’t dismiss it either. That said, variables won’t always win. At some point, long-term fixed rates will outperform, and that someday may have already happened.

Had you snagged the lowest five-year fixed mortgage in August, 2017, (right after the bank of Canada’s first rate hike of this cycle when five-year fixed rates were about 2.59 per cent) you would now be ahead of someone choosing the cheapest variable at the time (1.99 per cent). That’s based on interest cost alone, not factoring in penalties or refinance costs if you broke your mortgage early.

Could this time be different for fixed rates? Maybe. Blindly expecting to win in a variable based on research is “like saying, ‘Historically, stocks beat the bonds,’ ” Mr. Milevsky adds. “That doesn’t mean that every year it’s going to happen.”

 

Sticking to the plan, or not

For those out mortgage shopping, today’s rate hike is not a game changer. If you can find a variable rate that’s at least 0.75 per cent below a fixed, and you’re well qualified and/or aggressively pay down your mortgage, variables are still worth betting on. “The probability of winning with a variable will likely never fall below 70 per cent,” Mr. Milevsky says. “The odds will still be in your favour.”

And the higher rates go, the more the probabilities favour variables. That’s largely a result of the tendency of variables to revert to their mean after rising for a while.

But here’s the key to maximizing success in a variable. You must be well qualified, and you must shop rates aggressively. Settling for an average rate can be the difference between winning or losing in any rate you pick. “The bigger the rate discount [on a five-year fixed] the lower the probability” of saving more interest in a variable, Mr. Milevsky says.

Apart from that, deciding on whether to float your rate depends heavily on three things, Mr. Milevsky concludes:

  1. Are you renewing a mortgage or getting a new mortgage for the first time? (Mortgage experience matters, and the former can usually handle more risk.)
  2. How much equity do you have? (If you’re highly leveraged with just 5 per cent to 10 per cent down, and “every dollar counts,” fixed is usually wiser.)
  3. Do you have salary stability? (High unemployment risk, variable income, self-employment and/or income linked to real estate are all reasons to consider locking in, he says.)

Picking a mortgage term is like investing: there are no guarantees. Variable rates are ultimately a risk-return trade-off, Mr. Milevsky says, and every borrower must remember that going in. In the long run you’ll save more in a variable … unless perhaps you were lucky enough to lock in last year.

Even Beyonce and Jay-Z have a mortgage.

General Simon Wong 7 Oct

It was intriguing to learn that billionaire superstars Beyonce Knowles and her husband Jay-Z financed the purchase of their $88 million Californian mansion last year with a $53m mortgage from Goldman Sachs.

The Wall Street Journal revealed that the power couple’s mortgage payments will be more than $200,000 a month, with a fixed interest rate of 3.4 per cent that will become adjustable in 2022.

Is it any wonder that with money so cheap even the richest American entertainers are tempted to treat their home as a giant ATM?

With US stock markets seemingly on a never ending upward trajectory you can easily forgive this exuberance. But as so often in show business appearances are deceptive.

Hip-hop star Jay-Z has a track record as an entrepreneur. The music streaming business Tidal that he bought for $56m two years ago is currently valued at about $600m, partly thanks to its role as the exclusive launch platform for his wife’s last album Lemonade.

He and his equally famous wife are worth a total of $1.25 billion on the latest Forbes list. Her annual earnings? Around $100m; but Jay-Z’s fortune is reckoned to be the larger at $900m.

Perhaps if you have Jay-Z’s flair for private equity investment and business then borrowing against your real estate assets at low rates is always going to be a winner.

However, any personal financial adviser would have to counsel against such an approach for the average investor.

Indeed, for the average person who’s just come into some money it would probably be one of the surest routes to financial suicide.

 

Generally the first thing you should do with excess cash is to pay down your mortgage. Even with mortgage rates as low as they are today, say around four per cent in the UAE, that is way more than any local bank deposit account would pay you.

Therefore by releasing your mortgage you effectively give yourself a four per cent annual interest payment on the cash that was previously idle.

I remember one person doing this just before the global financial crash hit Dubai. When presenting the cheque the surprised bank teller told him: ‘No you don’t understand. We want to lend you more. You don’t need to pay this off at all.’

Many will not need reminding about what happened next in the Dubai property market. Suffice to say it must have been a source of considerable comfort not to have had a large mortgage hanging over your head during this period.

Wealth managers were also only too quick to advise this individual that much higher returns could be obtained by investing in diversified global financial markets. Within a year he would have lost half of his money, after paying a very large commission of course.

I don’t pretend to be an accurate forecaster of financial markets. But with interest rates on the way up around the world they do look very overvalued. It does not matter whether you look at equities, bonds, or real estate.

The recently published UBS Global Real Estate Bubble Index 2018 showed six major markets at bubble risk – Hong Kong, Munich, Toronto, Vancouver, Amsterdam and London – and serious imbalances in 10 other global cities, though no Gulf cities were on the list.

Bond prices are directly linked to interest rates, so hardly look a buy at the moment. US equities have only ever once been more highly valued, just before the dot-com crash.

Nobel prize winning economist Professor Robert Shiller says this year’s run-up in US stock prices is similar to the excesses seen before the Wall Street Crash of 1929.

Even the mighty expansion of the Chinese economy is slowing down under the weight of huge debts, growing trade tariffs and the upcoming de facto embargo on oil exports from Iran.

Last month one of the media world’s billionaires, Rupert Murdoch, cashed out of his creation Sky TV for $15.3bn, a fantastic compensation for a failed bid for the whole company. Perhaps he will be happy it worked out this way.

Large amounts of money being paid for businesses offering uncertain profits are a classic sign of the top of any business cycle, and the current one is close to being a record length.

When those around you seem to be losing their heads, it is imperative that investors keep theirs. Certainly don’t take a hip-hop entrepreneur and his high-earning wife as a role model.

Five years ago I was reviewing a new Michelin-starred restaurant in a Paris hotel off the Champs Elysee when Jay-Z and Beyonce were in residence, and it was quite clear from talking to the management that they were extremely high spenders.

Then again being frugal, if you are as rich as these stars, might seem a waste of money.

Warren Buffett still lives in the same house he bought 60 years ago, and seldom borrows to buy anything. In fact, he loaned Goldman Sachs $5bn in the last global financial crisis.

It will be interesting to compare the near-future financial success of the Sage of Omaha and this celebrity power couple.

As usual Mr Buffett leaves himself with no downside risk, aside from market price fluctuations, and his last reported record cash holdings were $111bn.

Consider what might happen to Jay-Z and Beyonce’s fortune if the US property bubble bursts and that jumbo loan on their property leaves them owing more than the value of their home. And what if the money from that loan has been invested in other assets whose values crash?

Gearing up your investment portfolio only works effectively when asset values are rising and it is a fast way for the rich to become richer.

Throw that gearing into reverse in a falling market and big debts are the fastest way to come completely unstuck. The history of personal finance is strewn with examples of such bankruptcies.

Now is a good moment to review your portfolio and eliminate debt by selling off what will probably later come to be seen as overvalued assets, while you still have the chance.

Better still, raise a positive cash balance to prepare yourself to pick up bargain assets in a coming correction phase in markets, as Mr Buffett has so successfully done in the past.