Since at least half of my readers are intelligent and awesome, (don’t worry, you’re totally in that half) I’m going to take a break from dispensing the advice and turn to you guys for a little guidance. Or, what’s more likely to happen, I’ll come to a conclusion on my own after writing the post, and I won’t need your help anyway. It’s okay though, feel free to leave me your two cents in the comment section. As always, it’ll be ignored.
As Financial Samurai likes to remind us every 17 seconds, interest rates are super low right now. Because so many investors are fleeing the stock market for the safety of bonds, they’ve driven the price of these bonds up substantially. Since there’s so much demand, interest paid to the borrowers is extremely low. This is bad news for investors, but good news for borrowers.
Enter my situation
Amount owed: $150,000
Remaining amortization: 16 years
Current payment: $450 bi-weekly
Current interest rate: Prime minus 0.3% (currently 2.70%)
Term expiry: August 2013
You should note that the mortgage amount owing, payment and amortization are all approximate numbers. I could find out the exact amounts, but I’m lazy. Some people manage to run their finances without micromanaging them.
I was reading the wonderful Canadian Mortgage Trends website, and they informed me of a promotion ATB Financial was having. For the next little while, ATB is offering a five year fixed mortgage for 3.09%. This is only 40 basis points above my current rate. This is a very cheap fixed rate.
First of all, let’s look at the cost of switching lenders. Because I went with the variable rate mortgage back in 2008 when I bought my house, my mortgage rate crept down with rates in general. For a little while, I was paying a mortgage just a hair above 2%.
As you might recall from one of my posts about mortgages, payout penalties are either 3three months interest or the interest rate differential between my current mortgage and the same mortgage now. Since there’s no difference between what I have and what’s offered (because of the variable rate), I’d be stuck paying the three month interest penalty.
Three months interest: $983.06. So I’m looking at a penalty of about a thousand bucks.
Let’s assume I roll that penalty back into my mortgage, so this process doesn’t cost me anything out of pocket. My handy dandy mortgage calculator tells me that if I keep my payment the same, I’ll add about a half a year on to my amortization. The amortization goes to 16.45 years from 15.8 years.
There’s going to be an additional cost for interest, at least at first. Currently I’m on pace to pay $3925 in interest. If I switch to a 3.09% rate, I’ll have to shell out $4527 in interest. $600 a year is nothing to sneeze at, and I highly suspect I’ll be paying it for each of the next two years.
But what happens then? Expectations are that interest rates are going to stay low for an extended period of time. But just how long will that be? Let’s look at a couple of scenarios:
First of all, we have what most people think will happen. Rates will stay low, the Bank of Canada will sit on the current rate, since the economy could use some stimulation. If this happens, I’m better off staying with my current mortgage and only refinancing when my expiring term forces me to do so. I’ll avoid a penalty that way, and I’ll have my pick of lenders offering the same low rates as today.
Scenario two is that rates start to creep up a year from now. The economy has started to recover sooner than expected. For the sake of argument, let’s say the Bank of Canada has raised rates twice, pushing prime up to a still reasonable 3.5%. At this point, my variable rate has become 3.2%.
Traditionally, the spread between five year fixed and variable rates has been between 1-1.5%. So if variable is 3.2%, a five year fixed would be anywhere from 4.19%-4.79%. If the economy recovers, we’ll start to see more normal spreads between fixed and variable rates. If this situation occurs, I’ll be kicking myself for not locking in now.
What Does It All Mean?
As much as I crunch the numbers, this problem basically comes down to one question. Where will interest rates go in the next two years?
If they go up, even just a little, refinancing makes all sorts of sense at this current rate. If they stay the same, I’ve just paid over $2000 in an attempt to guess interest rate trends. While $2000 isn’t a huge amount of money, I’m still risking something on the guess.
The contrarian in me thinks rates can’t stay this low for long. I understand the market is a scary place right now, but we’re approaching bubble territory in fixed income. Just how long will investors accept a 2% return on a 5 year bond, considering inflation is close to 2%? I’d rather have my money sitting on the sidelines.
Remember when I said I’d figure out the situation myself? I’m still stumped. Readers, the floor is yours.