Guest Articles

Bucking the conventional wisdom on a fixed-rate mortgage

April 5, 2009


It is now widely-known that homeowners can save money by opting for a variable-rate mortgage over a fixed-rate mortgage in the vast majority of instances. Ben, an astute observer of financial matters, recently grappled with the question with his own mortgage and decided that with potential high inflation in the future and low spreads between fixed-rate and variable-rate, this might be one of those rare occasions when it makes sense to go fixed. According to Invis, a mortgage broker, fixed-rate mortgages can currently be had for 3.99% over 5 years compared to variable at 3.30% (Prime + 0.80%).

Should you go with a fixed-rate mortgage (FRM) or a variable-rate mortgage (VRM)? One thing is clear about questions of this nature: nothing is ever clear. In the same way that RRSP vs. mortgage vs. TFSA can never be answered definitively for all cases, the decision on whether to take a variable or fixed mortgage interest rate can also never be resolved in cookie-cutter fashion.

To paint broad strokes, banks charge a premium on FRM’s to accept the risk that money will not be so cheap in years to come – by accepting a VRM, and hence the risk, you stand to save money, historically, and on average.

Widely-reported Dr. Moshe Milevsky of York University authored a study in 2001, with a subsequent update summarized nicely here, where 90.1% of the time over 1950-2007 it was better to have chosen a VRM over a FRM (down to 77.1% if you have good negotiation skills and credit, and can secure a discounted rate). As discussed in the comments there, it would be nice to know what conditions existed in those minority of times when it was better to have a FRM, ie. historically, given that prime rate was x%, what was the probability that fixed would fare better than variable over the next finite time period?

Given that mortgage interest rates are currently at an all time low, one has to wonder whether historical studies have the same relevance when brought to bear on current market conditions. The spread between VRM and FRM is extremely slender at the moment – on a standard 5-year term closed mortgage, the best discounted VRM today is just north of 3% and the best discounted FRM is about 4%. The narrower this gap, the better one’s probability of doing better with a FRM.

Some have argued that when rates do begin to go up, as they almost certainly will in time, the increases will be modest at first and at that point early in the rise one can lock in to a fixed rate. However, it is a certainty that by the time the average Joe realizes it’s time to lock into a fixed rate, the banks will have raised the fixed rate higher than he could have gotten today. This becomes a case of pay less today on your VRM, pay more tomorrow on your FRM.

In a recent discussion, Dr. Milevsky states generally that people with a lot of assets and therefore increased ability to deal with risk should still consider a VRM. Dr. Milevsky offers that those with small home equity, or low or unstable income, may want to consider a FRM.

Historical studies aside, there are some elephants in the room these days. Job stability is at generational lows, house prices are in steady decline, the future of North American automakers hangs in the balance, and governments are pumping trillions into the financial system with uncertain results. These are uncharted waters.

Ultimately with mortgage rate choices, as with all other aspects of personal finance, it comes down to risk management. If we pull out all the stops in efforts to maximize the slice of pie at retirement, we run the risk of burning the pie, or finding we’ve arrived at the dinner table without a plate and fork. If we don’t take the occasional calculated risk, however, we may find that there’s not enough pie to eat on Tuesdays.

And as always, more important than the decision you make on VRM vs. FRM is the decision you make in your day-to-day life to control your expenses, increase your income, and direct the net savings toward paying off the mortgage and maximizing registered and non-registered investments.

[Update: You may want to check out this post on Canadian Mortgage Trends on the same topic.]

Who are really the smartest guys in the room? How Insurance Companies Forgot Their Way

December 17, 2008


Today’s guest post is courtesy of the author of the Thicken My Wallet blog. You can subscribe to the feed here.

I want to thank Canadian Capitalist with giving me the opportunity to guest post on his well-deserved vacation. If you are a regular reader of this blog, you know that Canadian Capitalist is rightfully a passionate supporter of the KISS (keep it simple stupid) principal of personal finance (my words, not his) and that fees destroy returns over the long term.

As this age of financial excess is unwinding itself ever so painfully, it is interesting to note how the smartest guys in the room are probably not the financial wizards the media makes them out to be.

For example, CC wrote a recent series on Manulife’s IncomePlus products — a stunningly successful product for the company. But, as CC noted, the product had many flaws including an outrageous MER of approximately 3.5%. A moderately educated investor could replicate the product’s return using a portfolio of bonds.

So Manulife has designed a fail-proof product for itself and we should invest in the issuer and not the product right? Well… the Globe and Mail ran an interesting article on Manulife’s recent troubles resulting in part from products like IncomePlus.

In the simplest sense, insurance is like banking without money. Like banks, insurers are regulated and the regulators demand that a certain portion of money be set aside to cover its liabilities. Conventionally, an insurer’s largest liability is that all of the insurance policies it underwrote are called at once (analogous to all the bank’s customer’s withdrawing their money at once). The chances of everyone passing away at the same time are quite remote so an insurer’s risk is, statistically speaking, quite low.

But, insurance companies started dabbling into more exotic financial instruments. One such product is something known as viable annuities. Like a regular annuity, an investor pays the insurance company a sum of money in return for guaranteed payments in the future.

However, an investor in a variable annuity is also asking the insurance company to invest the money in the stock market for them and to participate in any profit the insurance company makes (IncomePlus is a variable annuity). The key attraction is that no matter how badly the insurance company invests your money, the investor will be guaranteed a stream of money in the future- so, theoretically, no down-side, all upside.

If you are a regular reader of this blog, you understand that active management of funds statistically underperforms the board based equity index. Thus, even in regular markets, one is already giving money to the “smartest guy in the room” (sorry, they are mostly guys who got us into this mess) to under perform.

In markets such as this? Remember that the insurance company has to guarantee the annuity payment but it has taken the investors’ money and lost a lot of it in the stock market. The only way to make up that loss is to take profits and top up the reserve fund mandated by the regulators to ensure that the annuities are paid on time.

The topping up of reserve funds can only be accomplished mainly through a couple of different methods: (i) issuance of new shares, creating a dilution issue; (ii) raising debt, leveraging the company more; and/or (iii) move profits into the reserve fund, reducing earnings per share. Manulife has done all three and its shareholders have suffered as a result; it posted its first loss ever since the company went public.

Why didn’t Manulife hedge its position? According to the Globe article, it stopped doing it in 2004 (remember they thought they were the smartest guys in the room).

Is Manulife in trouble? It will most likely feel a lot of short-term pain but its trouble pale in comparison to many of its industry counterparts and the money in the reserve funds can be moved back into earnings over time (to be clear, this is an industry issue not particular to Manulife).

Is a Manulife annuity in trouble? Most likely not since it reserve funds have been sufficiently topped up (in other words, it has the money).

The moral of the story?

The smartest guys in the room are not very smart when it is not their money.

The author is a shareholder of Manulife and, obviously, not a very happy one.

The Amateur Investor Manifesto, Part 3

December 14, 2008


In past posts (Part 1, Part 2) in this series, Reader J talked about his investment goals and his thoughts on his overall asset allocation. In the last post in this series, he discusses which funds he plans on using to capture exposure to different asset classes.

Asset Allocation
So based on my hare-brained idea of mixing indexes I’ve got to split the overall allocations further into the actual ETFs that will make it up. I don’t know the best way to do it properly, so I’ve often taken the coward’s way out and split it at arbitrary amounts. The equities are shown broken down into the % of the asset class and % of the portfolio as a whole.

Canadian Allocation
I’ve split this allocation right down the middle, half for the standard S&P/TSX Index and half for a value / small cap equities. For this second part, I used 35% of a RAFI fundamental index, which apparently has more of a value tilt and then 15% small cap:

50% / 8% — iShares Composite Index (XIC)
35% / 5.6% — Claymore Canadian Fundamental Index (CRQ)
15% / 2.4% — iShares SmallCap Index (XCS)

United States Allocation
This split was even murkier because the Total Stock Market has exposure to all US stocks (small, mid, large, growth and value), I wasn’t sure how to tilt it to value & small cap. The super-low fees are awesome and make it even harder to justify combining with a fundamental index which costs nearly ten times more (MER of 0.65% vs. 0.07%). Also it should be noted the RAFI fundamental index is hedged in Canadian dollars and as explained earlier, my hope is that this allows the portfolio to carry a lower percentage of Canadian equities without as much currency risk.

In previous revisions, I had selected 2 different small-cap funds. The Russell 2000 index was eliminated because apparently right before the index is reconstituted it would be subject to price volatility that would drag performance by 1-2%. Then the iShares S&P SmallCap 600 was eliminated simply because Vanguard’s MER of 0.1% was half as expensive.

48% / 13.2% — Vanguard Total Stock Market (VTI)
40% / 11% — Claymore US Fundamental Index (CLU) – Hedged
12% / 4.13% — Vanguard Small Cap (VB)

International Allocation
Vanguard has great fees, so it’s an easy choice for a standard cap index. The interesting thing here is the RAFI fundamental index doesn’t hedge the currency. I found out even though these funds are in US dollars there is no US currency risk, the currency risk should be less volatile because it is actually Canada against a basket of currencies. I haven’t been able to find a small cap international index.

60% / 14.55% — Vanguard Europe Pacific Index (VEA)
40% / 9.7% — Claymore International Fundamental Index (CIE)

Emerging Markets Allocation
Vanguard has the lowest fees for international and there doesn’t seem to be much else I can do to add a value / small cap tilt, especially since the allocation is such a small part of the portfolio.

100% / 4.25% — Vanguard Emerging Markets (VWO)

I’ve split Real Estate into 75% Canadian, 25% International. The question here comes from iShares REIT Sector Index XRE. It has a high MER of 0.55% but only a few equities. With my estimated starting allocation of around $30,000 it might be best to unbundle and save a bit on fees. This is appealing because I’ve never bought and sold stock myself, this could serve as an interesting lesson. The next idea is what about owning REITs in a DRIP plan which has no fees, plus lots of real estate trusts give drips a 3% or more bonus/discount. It would be more work and harder to rebalance, is it worth it? Would a REIT portfolio try to mirror the cap weighted index or evenly spread out between different types of trusts (malls, offices, senior’s homes, residential, etc). Is it worth it?

75% / 6% — iShares REIT Sector Index (XRE)
25% / 2% — Wisdom Tree International Real Estate Index (DRW)

Cash & Bonds
For the cash component of the portfolio I feel safer having 6 months of core living expenses in a cash emergency fund in high interest savings accounts, current this is about $16,000 or 4% of the total portfolio.

The remaining 16% is going to be invested in short term bonds with the goal of lowering equity risk. The Sleepy Portfolio uses the iShares Bond Index (XSB) but I am planning to use the lower cost Claymore 1-5 Year Laddered Government Bond ETF (CLF). Since it lacks higher yielding corporate bonds present in XSB, so would it make sense to split the bond allocation further with 80% CLF and adding 20% of iShares Corp Bond Index (XCB)? Combined the weighted MER would be 0.2%, instead of 0.25% for XSB. Is it worth it?

How and at what point should you buy real bonds directly?

40% / 8% — Claymore 1-5 Year Laddered Government Bond (CLF)
10% / 2% — iShares Corp Bond Index (XCB)
50% / 8% — High Interest Bank Accounts