Variable rate question? answered:)

I was asked the following question from a client and thought others may find this helpful...

Hi Dan,
I have a question I am hoping you can help me with. If you go with a variable rate mortgage and you have the option to lock in, when can I lock in, and is it at the current rate or is there a pre-determined rate you would have to lock into.
For example you indicated a variable rate of Prime - .65 (2.35%) if that was for a 5 year term and you were worried the Bank of Canada is going to increase rates would you be able to lock in at 2.35% for the remaining term or when you lock in you would be locked in at a different rate ie: 2.75% for the remainder of the term.
I am really curious how that works and was not exactly sure.
Thanks

ANSWER...

The benefit of a variable rate mortgage is that at any time during the term, it allows you to lock in to a fixed rate term with no penalty. You usually have to lock in to a term at least matching the remaining term in your variable rate mortgage. ie. If you are in the 3rd year of your 5 yr variable rate mortgage, you have to at least lock in to a fixed term of 2 years.

The problem(or advantage depending on how you see it) with a variable rate mortgage, is that you have a floating rate, based on Bank Prime(today 3%), so prime minus .65% today would give you a rate as you had mentioned of 2.35%. So as prime increase or decrease, so will your rate.

Prime has not changed since 2010, and in most people’s minds is NOT expected to decrease, the most likely possibility is that it will increase, the unknown is WHEN that will begin. Don't we all wish we had a crystal ball!

As mentioned earlier, if prime were to start to increase, you can at any time lock in to a fixed rate term with that same lender with NO penalty. The catch though is at what rate? There is NO GUARANTEE of any rate until the day you decide to lock in. It is NOT PREDETERMINED. Whatever the lender offers you on that day is the rate you will get. So if you hear on the radio that 5 yr rate went to 4%, and you decide to "chicken out” and lock in, you know you will get at least that rate. So that 2.89% 5 yr fixed rate today that you may have chosen NOT to take when you took a variable rate, is gone. You get whatever rate you get at the time when you lock in.

On a side note, this is why you should NEVER take a variable rate mortgage with any bank. "Banks" have posted rates, ie 5 yr fixed today at 4.85%- check their web site. So when you go to lock in from a variable rate mortgage, which has nothing in writing stating what discount you will get when you lock in, what

rate do you think you will get? Especially when the bank knows you CANNOT leave from a variable rate mortgage, without a 3 month interest penalty! As a broker, I only do variable rate mortgages through lenders that have rates on their sites similar to what you would have been offered if you had taken a fixed rate mortgage in the beginning. ie 2.99% as opposed to 4.79% today(Dec 5th,2014)

The big decision therefore becomes what do I take, variable or fixed. A variable rate at 2.35% today or a 5 yr fixed at 2.89%. There is no right or wrong, as no one today can tell you where rates will be 2 years from today. It is only in the future that you will be able to look back and determine whether or not you made a financially wise decision. A forecast into the future is only that, a forecast with no guarantee.

For those of you who have followed this post for some time now, you know I am a conservative fellow. The rates in general today are at an all-time historical low, with 5 yr fixed being as high as 21% in the early 80's, 10.3/4% in 1988, to where they are today, 2.89% 5 yr fixed. If you are borrowing a large amount of money to buy a house at the maximum limit of your budget, you probably shouldn't be taking a variable rate. If you are financially secure with a smaller mortgage and room that if rates go up you can afford the increased payments, then maybe you can afford to take the gamble on a variable rate. Its a personal choice.

Myself personally, I would still choose the fixed rate. I don't believe the spread between a 5 yr fixed and a variable rate(2.89% -2.35%=.54%) is worth the gamble. I would go with the security of a fixed rate, and payment for the next 5 yrs, but that’s my choice, and I'm sure many of you may choose to differ.

Always remember to see beyond any rate, and ensure that you understand the mortgage you take, and know what it does and does not offer. The fine print is always important.

A real life story of the pitfalls of a collateral mortgage…

A client (we’ll call him John Smith) came in to see me.
He owns a home worth $375,000.
He told me he has $25,000 outstanding on his mortgage.
He also told me he has a $250,000 secured line of credit on his home that is fully advanced.
Total owing is $275,000.
This is what the client thinks he has.

What the client didn’t understand is that when the bank gave him the L/C for $250,000, they refinanced the property and gave him a new 1st mortgage with $25,000 as a fixed portion and $250,000 as a secured L/C portion. Both are simply one mortgage with two parts, total borrowed is $275,000.

What he also didn’t NOT know (he was told in very fine print, but NOT explained) is that the mortgage was in fact registered against his home for $375,000, the full value of his home. But remember that the bank only lent him $275,000.

What he now knows is that he has a “collateral” mortgage. Most collateral mortgages register at 100% of the property’s value, sometimes up to 125%, depending on the lender.

So where is the problem? This year Mr Smith has decided to sell his home, and needs to do some renovations before selling the home in today’s competitive market.
He approached his bank to borrow another $25,000, and due to income not qualifying, this time they said they couldn’t help him. Sorry, they said.

So Mr Smith comes in to see me, and I have to tell him that because he has a collateral mortgage that is registered for 100% of the property’s value, I can’t get him any more money. Even though he has only borrowed $275,000, and his property is worth $375,000, the mortgage is registered for $375,000. There is technically no equity in the home for me to mortgage against.

In fact NO ONE else can give him a mortgage. There are no options; he can’t get any further money from me or anyone else using his homes equity. He has a big PROBLEM, that NO ONE can help him with, except for his bank, who has said, SORRY, we can’t.

The lesson to be learned here is to think VERY carefully before accepting a collateral mortgage from ANY bank. And the real life example I have given above is just one of the problems associated with having a collateral mortgage. There are many more that I will let the following article summarize more of.

http://www.thestar.com/business/personal_finance/spending_saving/2011/07/30/beware_the_pitfals_of_collateral_mortgages.html

As of the writing of this, T.D. bank, National Bank, and Tangerine are registering all new mortgages they give as collateral mortgages. As well, any mortgage with any bank that has multiple products in one mortgage is also registered as collateral.

So long 2013...

As I sit in a quiet office on Friday Jan 3rd, it’s hard not to notice that though the New Year has begun, seems like everyone is still off work. Richmond Rd, which I normally cross at 8 am to get my morning coffee, was eerily quiet today, reminding me that maybe I should be off too, enjoying what’s left of the holiday season. But this is the best time, while the phones are quiet and no one is around, to get the last of my end of year administration stuff done, in preparation for the new year ahead. It’s the paper work that you avoid that always takes the most time, and the less people around to distract you, the sooner it’s done.

In our industry, 2013 brought a number of changes that affected the average borrower and therefore how we do business. The maximum amortization which in 2012 was 30 years, was dropped to 25 years. If you took a mortgage term shorter than 5 years, you are forced now to qualify on a government set bench mark rate that is much higher than the actual rate you were getting. Both changes in the governments eyes, meant to tighten up the lending guidelines, and force the public into being more conservative in their borrowing practises. Even the qualifying ratios that CMHC uses to qualify purchasers were reduced. Again this year, restrictions imposed to keep us from over borrowing, and the hope that the housing market will not stumble, or at least only slow at a reasonable rate. We don’t want to relive the American housing bubble, here at home!

In my personal life, it’s also a time of year to do the annual New Year resolutions. I an article I read earlier they suggested we see the resolutions as “commitments”, and I think I will also change my though process to that. Not something I will try to achieve, but rather something I will commit to doing or achieving.

So for whatever it is you choose to “commit” to for 2014, I hope that some will bring more happiness in to your lives, and some will be to bring you more prosperity. I have placed a link below to a Globe and Mail video, that I thought, though quite general, would be a good start for all of us with our financial plans.

http://www.theglobeandmail.com/report-on-business/video/rob-carricks-top-5-personal-finance-tips-for-the-year-ahead/article16124745/#dashboard/follows/

So in closing, I would like to wish everyone a Happy and Prosperous 2014. We’re only here once, so take life by the horns, and make it what you want it to be.

Dan :)

“We cannot control how our life begins or ends. We can only control how we live it.”