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Mortgage regret: Canadians may pay dearly for locking in

Turns out the sky is not falling.

After 18 months of warning that skyrocketing interest rates will wash over vulnerable homeowners like a tsunami, the Bank of Canada is hinting that its next interest rate move will not be up – but down. Either way, most economists say the benchmark rate will remain right where it’s been for over three years – 1 per cent - until at least some time in 2015.

The reason? The Bank of Canada and most economists have been overestimating the need to raise interest rates to control growth, and underestimating the weakness in the global economy. Emerging market powerhouses like China have been losing steam and the U.S. economy is still lumbering along. That means weaker demand for the resources Canada exports. It also means slower economic growth, continued high unemployment and a smaller chance the boss will be giving out raises this Christmas.

But that hasn’t stopped bond and mortgages rates from creeping up. This week the Bank of Montreal raised rates on its one, two, three, four and five-year closed mortgages by one-tenth of a percentage point. BMO now charges 5.44 per cent on a five-year closed mortgage. It should be noted BMO is among the most expensive mortgage lenders right now. According to mortgage broker website, RateHub, True North Mortgage currently has the lowest five-year closed mortgage at 3.28 per cent.


The fixed-rate fix

The Bank of Canada reversal is a kick in the pants for homeowners with variable-rate mortgages who were spooked by the banks, and even Federal Finance Minister Jim Flaherty, to lock into fixed-rate mortgages. While fixed-rate mortgages follow corresponding bond yields, variable-rate mortgages follow the Bank of Canada rate, which remains frozen at 1 per cent. To be precise, variable-rate mortgages follow each bank’s prime rate, which follow the Bank of Canada rate.

Most bank prime rates are currently 3 per cent – 2 per cent above the Bank of Canada rate. As examples, BMO offers a 4.1 per cent variable rate mortgage (prime plus 1.1 per cent), and True North Mortgage offers a 2.39 per cent variable-rate mortgage, or prime minus 0.61 per cent.

Variable-rate mortgage rates are normally much lower than fixed mortgage rates because there is a risk they could change without warning along with the Bank of Canada rate. In a more normal interest-rate environment, a variable rate mortgage leaves the borrower vulnerable to sudden spikes in the central bank rate.

The price of locking in

These are not normal times. It’s become clear the Bank of Canada rate isn’t moving until at least the middle of 2015. That means variable rate mortgages holders who heeded the warnings 18 months ago and locked in will have been paying the higher fixed rate for three years.

To get an idea of how the Bank of Canada blunder could cost a typical mortgage holder thousands of dollars in extra interest charges assume let's take a look at an example.

If you shifted from a variable rate mortgage at 3 per cent to a 5-year fixed mortgage at 4 per cent 18 months ago. Let’s also assume the likelihood those rates average out at the same level and maintain a difference of at least 1 per cent for the next 18 months.

In that three-year period that extra 1 per cent on a $300,000 mortgage adds up to $9,000 in interest to the bank - $9,000 that will continue to generate compound interest for the bank until the house is paid off.

It’s true the extra cost of a locked-in mortgage provides security from interest rate swings, but that’s a big price to pay for fear based on misinformation.