Wednesday, November 30, 2005
Rates Rise: now what ?
And I thought I was the only one knowing it! Over the past three days I have received six telephone calls and four e-mails all from alarmed people (one my own niece) very concerned about rising mortgage interest rates, and all asking the very same, panicking question: ‘Now what’? For one thing, you could try doing nothing about it – it normally works well for me and, who knows, perhaps with a little luck tomorrow interest rates will drop. For another thing, you may want to hug your Teddy Bear – and buy one also for your friendly neighborhood banker, turned overnight into a voracious T-Rex.
When you last went shopping for a mortgage you found yourself facing an array of options, from a six-month ‘open’ to a 10-year ‘closed’ and everything in-between. And chances are you didn’t quite grasp or paid attention to the differences among all those many options, mostly because you never envisioned a time of interest rates increase. Now that the tide is changing direction, of course, the basic question becomes the most important: which option is the best to minimize mortgage costs? To answer this, let’s take a look first at a few definitions.
For starters and contrary to popular belief a mortgage is not a loan. It is both an interest in land created by contract and a type of security for a debt. In essence, a mortgage is not a debt but, rather, the evidence of a debt. More importantly, a mortgage is a transfer of a legal or equitable interest in land on the condition that the interest will be returned when the terms of the mortgage contract are fully satisfied. This usually means upon repayment of the underlying debt. Mortgage Law originated in the English feudal system as early as the 12th century. At that time the effect of a mortgage was to legally convey both the title of the interest in land and possession of the land to the lender. This conveyance was ‘absolute’, that is subject only to the lender’s promise to re-convey the property to the borrower if the specified sum was repaid by the specified date. If, on the other hand, the borrower failed to comply with the terms, then the interest in land automatically became the lender’s and the borrower had no further claims or recourses at law. There were, back in feudal England, basically two kinds of martgages: ‘ad vivum vadium’, Latin for ‘a live pledge’ in which the income from the land was used by the borrower to repay the debt, and ‘ad mortuum vadium’, Latin for ‘a dead pledge’ where the lender was entitled to the income from the land and the borrower had to raise funds elsewhere to repay the debt. Whereas at the beginning only ‘live pledges’ were legal and ‘dead pledges’ were considered an infringement of the laws of usury and of religious dogmas, by the 14th century only dead pledges remained and were all very legal and very religious. And, apparently, they are still very religious in the 21st century.
Mortgages are better known to consumers by their re-payment schemes:
Interest Accruing Loans
Typically used by builders, an interest accruing loan is one on which no payment of interest and no repayment of principal are required to be made during the life of the loan. These type of loan may be ‘closed’, i.e. booked at an interest rate fixed throughout the term of the loan or ‘open’, that is with a fluctuating rate. In effect, in this type of loan the lender actually to the borrower the additional amount corresponding to the interest payable during the term.
Interest Only Loans
Typically preferred by lenders, in this type of loan the borrower contracts out to make fixed payments of only interest to the lender, with the principal due in one lump sum at the end of the term. Obviously, the principal amount never increases because interest is discharged at fixed intervals.
Straight-Line Principal Reduction Loans
Favored in the United States and continental Europe, this type of loan has an equal amount of principal repaid every interest compounding period plus interest for the period. For example, a mortgage may call for complete repayment of principal over a fifteen-year period through monthly payments of interest, so that 180 payments will be made in the entirety of the term of the loan. The principal balance and the amount of interest due decrease over time.
Constant Payment Repayment Schemes
Favored in Canada, England and throughout the Commonwealth, these can be fully amortized or partially amortized. Payments are equal throughout the life of the loan and consist of both principal repayment and interest. However, as each payment installment becomes due, an increasing portion of the principal is repaid, thereby reducing the outstanding balance on which interest is charged during the next period. As a result of the decreasing principal balance on which interest is charged, interest as well decreases over time thereby increasing the amount of principal repaid each subsequent installment. When fully amortized, the principal balance is fully repaid at the end of the term. However, most loans are partially amortized so that repayment of principal plus interest are calculated so as to repay the debt over an amortization period which is longer than the term of the loan. This means that at the end of the term of the loan the principal ourstanding balance must either be paid off or it is refinanced for an additional term. Also, because of the way payments are structured, early payments consist largely of interest and little repayment, so that typically the principal outstanding balance at the end of the first terms is large.
Variable Rate Mortgages
This type of loan differs from a costant payment mortgage because the interest rate charged may be changed during the term of the loan., Generally, these loans are initially set up like standard, partially amortized payment repayment loans based on the current interest rate, Then the rate is revised at fixed intervals and the mortgage repayment scheme is altered as well by changing either the size of the payments or the length of the amortization period, or a combination of both.
The term ‘Open’ does not refer, like many people believe, to a fluctuating interest rate. The term ‘Open’ refers to the possibility granted to the borrower to pay off the loan without penalty prior to maturity. In general, lenders do not like Open Mortgages because the early payoff reduces the interest they earn. Open Mortgages can be written either wih a ‘fixed rate’ or with a ‘variable rate’. In Variable Rates Open Mortgages the payment stays the same, but what changes is the ratio of interest to principal. If market rates increase, principal repayment decrease during the life of the loan.
In general, Closed Mortgages offer a better rate than Open Mortgages but the drawback is the borrower is not afforded the right of payoff at anytime. If the borrower intends to payoff the loan, a penalty is applied typically amounting to three months interest payments. If the borrower anticipates making only fixed payments and no early payoffs, Closed Mortgages are usually preferable.
These are yet another variation of the same product wherein the rate is fixed for an initial period, say six months or even one year, with the provision that at any time during this period the borrower mat ‘lock in’ into a longer term with little or no cost. This is clearly the best mortgage if rates are in a downward trend.
Now that I have managed to drive you up the wall, let me point out that another couple of considerations ought to be made by the expert consumer (which, by now, it is definitely not you …):
Fixed v.Variable Interest Rate Mortgages
The choice is whether the borrower prefers the security of fixed payments as opposed to the volatility of the market. Typically, security of fixed interest rates comes at a premium: the borrower can fix the principal repayment and interest for a term ranging from 6 months to 10 years, but the longer the term the higher the rate. On the other hand, Variable Interest Rate Mortgages will fluctuate sometimes literally overnight with the market, but interest rate will typically be less. So really, the choice is between the security of fixed rates and the potential savings afforded by a fluctuating variable rate.
Short v. Long Term
Short Term Mortgages are appropriate when the borrower believes that interest rates will fall substantially by the time renewal date comes up. Alternatively, Long Term Mortgages are suitable when current interest rates are reasonable and it is deemed preferable to lock in so that a budget can be laid out for future fixed payments.
So, again, going back to the original question which option is best to minimize costs? To find out, Canada Mortgage Housing Corporation (CMHC) developed the measure of effective mortgage rate differential between five-year and one-year mortgage rates over five-year moving spans between 1980 and 2005. The model assumes that the borrower has the option every year of taking on a five-year mortgage term or a one-year mortgage term at the rates then prevailing, and that there is no difference in mortgage principal. The results are surprising. CHMC has found that it is cheaper more than 85 percent of the times to opt for a one-year term and roll it over than to take a five-year mortgage up front.
More importantly, CHMC has found that borrowers with Variable Rate Mortgages benefited of substantial savings over each five-year span than their Fixed Rate Mortgages counterparts. Whereas they paid more interest in the short term they ultimately and invariably ended up saving more over the long run, which then gives credo to the belief that security and peace of mind when it comes to mortgages are purely a matter of perception.