Interest Rates and 2014

The Canadian mortgage market favours five year fixed rate term renewals, and as such the prospects for those looking to renew mortgages in the coming year matters for inflation as well as credit growth. A borrower has a few options at renewal time, including continuing to amortize a loan on its original schedule, refinancing for a different loan amount, and changing between fixed and variable rate over various terms. Now-retired "Vancouver Housing Blogger" brought us the concept of the "renewal gap", the interest rate differential a borrower sees upon mortgage renewal, shown below for the 5 year fixed rate mortgage using the "average residential mortgage rate" as reported by CMHC, and the "posted" rate as reported by the Bank of Canada (note current rates are held as constant indefinitely into the future):

Extending this concept further, we can look in terms of change in payment, which depends upon whether a borrower refinances or re-amortizes. The four scenarios considered are:

• Borrower refinances a 5-year amortized $100,000 loan into another $100,000 25 year amortization loan (and pocketing the amortized amount) (blue line)
• Borrower refinances a 5-year amortized $100,000 loan into a $100,000 20 year amortization loan (and pocketing the amortized amount) (red line)
• Borrower continues a 5-year amortized $100,000 loan into a 25-year amortization loan (ie extends the amortization only) (yellow line)
• Borrower continues a 5-year amortized $100,000 loan into a 20-year amortization loan (ie continues the amortization schedule; this would be the scenario for a borrower who wants to continue with a government-insured policy loan) (green line)

The four scenarios are graphed below for the average lending rate, again assuming current rates are extended indefinitely into the future:

The blue and green lines overlap exactly. That is, a borrower deciding to refinance a $100,000 loan for 25 years or continuing to finance a loan five years into its 25 year amortization for 20 years is the same. If a borrower decides to refinance but not re-amortize, that results in a higher payment, and if a borrower decides not to refinance but to re-amortize, that results in the lowest payment in the scenarios considered.

Starting in 2012 and continuing all the way until today, all four scenarios resulted in lower mortgage payments compared to the previous five year term. Starting in early 2014, that scenario quickly changes, with only the re-amortization scenario offering any significant easing of payments. The sudden change in payment terms for borrowers will tend to reduce credit growth and yet be relatively inflationary through most of 2014 and all years hence, barring any significant drops in mortgage rates.