A for sale sign hangs outside a home in Toronto, on Dec. 13, 2021.CARLOS OSORIO/Reuters
Welcome to Mortgage Rundown, a quick take on Canada’s home financing landscape from mortgage strategist Robert McLister.
It’s hard to overstate how much is riding on inflation getting back near the Bank of Canada’s 2 per cent target.
If it does, as financial markets expect in 2024, debt jugglers and Canada’s real estate market might just avoid an economic faceplant. That’s the likely scenario according to the forward rate market, which projects future interest rates based on the hedging and speculation of bond traders.
On the other hand, if inflation throws us a curveball and lingers near 3 to 4 per cent – or gets a second wind and climbs even higher – we’re in for a rough ride. The Bank of Canada would hike rates again (likely multiple times), home values would dive and mortgage defaults could surge.
Few analysts expect that, but few expected the prime rate to almost double in 13 months from July, 1980, to August, 1981.
Currently, hordes of mortgage shoppers are choosing variable rates, assuming that the Bank of Canada will slash rates in 2024. But what if they’re wrong and borrowing costs climb to new long-term highs?
For some borrowers who choose a floating-rate mortgage, they simply can’t afford to be that wrong. That’s when hedging your interest rate exposure makes sense, and one way to do that is with a hybrid mortgage.
Hybrids let you split your mortgage into two or more rate types. It’s like ordering a half-and-half pizza when you can’t decide between toppings.
One half might be a variable at prime minus 0.60 percentage points (6.60 per cent). The other might be a five-year fixed at 5.59 per cent, for a total blended rate of 5.99 per cent.
Most such mortgages let you choose how much of your borrowing you want in each portion.
Why people choose hybrids
Hybrid mortgages are an answer to the tug-of-war between fear and greed. They let you participate in the pleasure of falling rates while helping you avoid some pain if rates soar.
Hybrids have two main advantages.
1. Rate diversification
A hybrid mortgage is like betting on multiple horses in an interest rate race. Over the long run, you win less, but when rates surprise higher, you also lose less.
Academics love hybrid mortgages for the same reasons they love diversified investment portfolios: cushioning you from unpredictability. Efficient markets theory holds that forward rates are a flawed view of future interest rates.
While there’s much debate about how flawed the theory is, there’s no denying that inflation can come out of left field. A combination of poorly-timed fiscal stimulus, supply shocks, a weak currency, imported inflation from the United States and short-term immigration effects could potentially keep rates higher than expected for far longer. A hybrid provides partial insurance against that worst-case scenario while letting borrowers play the odds of lower rates.
2. Optionality
Compared to a long-term fixed rate, hybrid mortgages reduce penalty risk if you break up with your mortgage before it matures. The reason is that a variable component has just a three-month interest charge, versus the brutal interest rate differential penalties of many fixed rates.
Hybrids also let you lock in the variable portion to a fixed rate if rates jump and you get nervous.
And if you come into spare cash and have no better uses for it, you can make a prepayment on the higher-rate portion to pay it down quicker.
Points to remember
Hybrids aren’t perfect. Switching hybrid mortgages to a new lender sometimes entails legal and appraisal fees, whereas regular mortgages can often be switched for free, apart from your existing lender’s discharge/assignment fee. And sometimes lenders will dangle cash-back deals or rebates to cover these costs.
Hybrids also run counter to research that shows variable rates cost less over the long term. That’s particularly true after rates rise far above their five-year average, as they have in this cycle. That’s why a fixed-payment variable rate mortgage is a smarter play for risk-tolerant borrowers who want to play the odds but still want some payment protection.
For hybrid borrowers who want their payments to move down with prime rate, but who can handle potential payment increases, an adjustable-rate mortgage (ARM) is best. (Note: Most hybrid lenders offer fixed-payment variable rates. Scotiabank and National Bank are two that let your payment float with prime.)
If you opt for a hybrid or variable, but want a safety net in case rates do a moonshot, consider coupling it with a readvanceable home equity line of credit (HELOC). That gives you a source of liquidity you can draw on to help with payments in a worst-case scenario.
Where do you get them?
Only a minority of lenders offer competitive hybrid financing. You’re left with select banks and a few credit unions. Examples include HSBC, Scotiabank, National Bank, BMO, Alterna Bank and RBC. Unfortunately, mortgage finance companies, which offer the lowest default-insured rates, do not sell hybrids.
Despite the benefits, hybrids aren’t winning any popularity contests. It’s not just obscurity keeping them in the shadows; it’s that their price tags are a smidge higher than the rock-bottom rates people love to chase. But for borrowers who don’t have a working crystal ball and crave variable-rate savings – without completely tossing caution to the wind – hybrids are a sleeper worth a look.
Robert McLister is an interest rate analyst, mortgage strategist and editor of MortgageLogic.news. You can follow him on Twitter at @RobMcLister.
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