Time to lock in? BMO says yes

The days of super-low mortgage rates that made home ownership dreams a reality of many Canadians may be numbered, says the Bank of Montreal.

The bank's advice? Say goodbye to variable mortgages and lock in longer-term fixed rates while the going is still good.

In a report released Friday, BMO economists Douglas Porter and Benjamin Reitzes argue that with the U.S. recovering gathering steam, central bankers on both sides of the border are becoming more comfortable with the economy and less so with historically depressed interest rates that in Canada are fanning the flames of the hot housing market.

Already, financial markets have priced in a close to 50 per cent chance that Bank of Canada governor Mark Carney will start hiking his one per cent policy setting before the year's end, they note.

"We just believe the tide on some of these longer-term interest rates is beginning to turn," explained Porter, the bank's deputy chief economist.

"You can get a five-year rate for 2.99 per cent. Today's inflation rate was 2.6 per cent; that's almost unheard of that you can borrow for basically the cost of inflation. I don't believe it's sustainable."

Both Finance Minister Jim Flaherty and Carney have recently flagged the danger to the economy of Canadians becoming increasingly indebted, mostly through taking advantage of low rates to buy homes or take out home equity loans. Household debt to disposable annual income is above 150 per cent and likely to rise further toward the 160 per cent level that preceded the housing collapse in the U.S., say analysts.

This week, Flaherty expressed some exasperation that banks are calling on him to stop them from making loans that Canadians may not be able to afford once rates start rising.

And both the Canada Mortgage and Housing Corporation, and the Office of Superintendent for Financial Institutions issued documents suggesting debt tolerance is being tested.

The BMO economists concede that variable rates have been the best option most of the time. Their report says variable has been the cost-effective route 84 per cent of the time since 1975.

"But recent rate competition has all but erased the spread between the five-year fixed mortgage rates and variable rates," they add.

"The bond market, in particular, is sending loud warning signals that the era of low interest rates may finally be drawing to a close. Government of Canada five-year bond yields have jumped more than 50 basis points in the past three months alone.

Porter notes that although variable rates usually follow the lead of the Bank of Canada, longer-term rates are more influenced by bonds. Higher bond yields increase the cost of funds for lenders,who in turn pass them on to customers.

"So even if variable rates take some time to climb, we may not see such low fixed rates again any time soon," he said.

In fact, the "special offer" 2.99 per cent five-year rate offered by many banks are due be withdrawn next Thursday.

The report offers several reasons for locking in, including that householders will attain certainty on how much they will be paying for five years, without worrying what will happen to interest rates.

The case of staying with a variable mortgage is that historically it has saved borrowers money, and given that inflation is tame, interest rates are unlikely to rise rapidly.

When they do, however, today's low fixed rates are unlikely to be available, say the economists.

"Our interest rate outlook now projects a significant advantage to choosing a fixed rate," they conclude. "While the decision still depends on the individual, a low rate combined with a shorter 25-year amortization would significantly strengthen a borrower's financial stability."