Fixed or variable?
That’s the question regarding mortgages as the potential for rising interest rates increases.
Farm Credit Canada suggests farmers assess their options in managing their debt.
About two-thirds of FCC’s $20 billion portfolio now consists of variable rate loans.
That made sense as the Bank of Canada kept its lending rate low in recent years to stimulate the Canadian economy.
But as the recovery takes hold and inflation rises, most economists believe the Bank of Canada will start to increase rates.
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If so, in some cases it might be a good idea to switch to a fixed rate loan.
But it is not a simple decision.
“It is such a fluid situation,” said FCC senior economist Jean-Philippe Gervais.
It is unclear how long the slowdown in the United States will last. Japan is still recovering from the tsunami and Europe is struggling with Greece’s debt situation, Gervais said.
“There is a lot of uncertainty out there.”
At its meeting at the end of May, the Bank of Canada said the “considerable monetary policy stimulus currently in place will eventually be withdrawn” if the economy grows toward full capacity.
That is economist speak for, “interest rates will eventually rise.”
Many commercial bank economists forecast that the central bank’s overnight rate will start to rise this fall and could climb to 2.75 percent by the end of 2012. That would put the prime rate at about 4.75 percent.
But it is conditional on growth.
Some economists think the current slowdown is temporary.
“The current lull in growth looks to be a one-time hit from gasoline prices and temporary supply chain disruptions, and if it gives way to a re-acceleration, monetary stimulus will have to be withdrawn,” said CIBC World Markets in a recent report.
But TD Economics thinks economic risks and the desire not to let the Canadian rate rise too much higher than U.S. interest rates will delay rate hikes until 2012.
Gervais suggests farmers watch the monthly Canadian inflation report and focus on the core inflation number when assessing the likelihood of rate increases.
“That is the inflation figure you read about in the media, minus energy and food prices,” he said.
Overall inflation was 3.3 percent in April, but core inflation was 1.6 percent, still below the central bank’s goal of two percent.
The output gap is another measure. It tracks the difference between the economy’s actual and potential output. It is still in negative territory, but there will be no need for stimulus once the economy reaches full potential, perhaps by the middle to end of 2012.
“As soon as we reach that full potential, when the economy is moving really fast, we have an overnight bank rate of, historically, around three percent,” Gervais said.
“Maybe you’d expect this time around it would be a little lower because we are starting from a level really low.”
Switching to a fixed rate loan before rates rise could save money down the road. As well, its predictability makes planning easier.
However, fixed rates could be more expensive if interest rates don’t climb. They also have penalties if borrowers want to pay off their debt early.
The decision on loan type depends on a farmer’s capacity for risk and should be assessed regularly.
“Now is as good a time as any to run the ‘what if’ scenarios: if commodity prices go up, if commodity prices go down, if interest rates rise,” said Gervais.
“I know producers like to be in the fields … but it is a sophisticated industry and really spending time crunching numbers is something positive and producers will see the benefits.”
