Fixed or variable? How to Decide When Interest Rates Rise
Fixed or variable? It’s a recurring question for mortgage seekers that is likely to come to a head as the Bank of Canada begins what should be a steady stream of interest rate hikes over the next few months.
On Wednesday, the central bank raised its key interest rate to 0.50% from a record low of 0.25%. This is the first rate hike since 2018. The increase will affect the cost of borrowing for various loans, including mortgages.
With a fixed rate mortgage, the interest rate and payment stay the same for the life of the mortgage. With a variable rate mortgage, the interest rate will move in line with the lender’s prime interest rate, which can take a week or more to adjust to central bank rate changes. In contrast, fixed mortgage rates are often set based on government bond yields. Both mortgage products, however, often feature lower or reduced rates than advertised rates set by lenders.
About three-quarters of mortgages were paid off in 2020, according to research from Mortgage Professionals Canada, suggesting that many Canadians prefer the certainty of payment that comes with a locked-in rate.
Still, variable-rate mortgages remain in high demand, accounting for about 40% of all new loans in the second quarter of last year, notes a report by Canada Mortgage and Housing Corporation, due to the significant discount between fixed and variable rates.
Borrowers who opt for variable rates should feel comfortable with fluctuating rates, says Ian Wood, certified financial planner at Cardinal Capital Management Inc. in Winnipeg.
“I would have a discussion with my clients about their decision, helping them understand their ability to manage rising interest charges within their budget,” he says.
Many borrowers don’t understand the financial impact of rising interest rates and may even overestimate it, says Leah Zlatkin, mortgage broker at Mortgage Outlet Inc. in Toronto.
“As a rule of thumb, you’re paying about $12 more per month per $100,000 mortgage for every 0.25% increase,” says Zlatkin, also an expert at Lowestrates.ca, adding that this can vary depending on depending on depreciation and other factors. .
She notes that the spread, or difference, in rates between a fixed and variable mortgage (based on five-year closed terms that generally offer the best rates) is wide enough that the Bank of Canada has to raise rates several times before most existing loans variable mortgages would have more expensive monthly payments than most fixed rate mortgages offered today.
For example, a typical five-year term mortgage on a home priced at $750,000 with a 15% down payment amortized over 25 years with a variable interest rate of 1.5% – discounted 1.2% below prime – has a monthly payment of $2,620. In contrast, a typical five-year fixed mortgage at 2.6% has a monthly payment of $2,970 (figures provided by Lowestrates.ca as of March 3).
Ms Zlatkin says the central bank’s benchmark rate would need to rise by at least 100 basis points, or 1%, to make the variable rate mortgage more expensive than the fixed rate mortgage. And that’s not taking into account the savings of $350 a month until the Bank of Canada raises rates enough that variable rate mortgages become more expensive than most fixed rate mortgages available today. .
Variable rate mortgages are also more flexible, especially if you terminate your mortgage before the end of its term. Ms Zlatkin estimates that up to six in 10 borrowers end up breaking their mortgage before the end of the term.
“They’re moving, renovating or breaking their mortgage for a variety of reasons,” says Jeff Sparrow, a Winnipeg mortgage broker and managing partner at Castle Mortgage Group, who sees this happen regularly with his clients.
Breaking a variable rate mortgage can result in a penalty equal to three months of interest charges, while breaking a fixed rate mortgage can result in a heavier penalty because lenders use what this is called an “interest rate differential” calculation. The penalty could be tens of thousands of dollars, depending on the size of the mortgage. By comparison, three months of interest will likely cost a few thousand dollars at worst, Sparrow notes.
Even borrowers who feel more comfortable with a fixed rate mortgage should consider variable rate products, says Zlatkin.
“You can get an adjustable rate mortgage, for example, where payments don’t increase with interest rate increases, but the amortization lengthens instead.”
Another strategy for an adjustable-rate mortgage is to take the difference in monthly payments between the adjustable-rate and fixed-rate mortgage “and apply that amount to the principal,” she says. “So even if rates go up six times, by the time that happens you’ll have paid so much more capital than you’ll probably still be way ahead.”
Of course, the biggest challenge for borrowers is that no one can predict where interest rates will be one year from now, let alone five years from now, says Wood.
“Everyone has been talking about rising rates for 20 years,” he notes, and yet rates are hovering around historic lows.
“But just because we’ve seen rates stay low for so long doesn’t mean you have to believe that rates will stay low,” he adds.
Holders of variable-rate mortgages can usually switch to a fixed-rate product without penalty from the same lender before the end of the term, Sparrow notes. But borrowers should understand that the interest rate offered on a fixed mortgage at this time is likely to be higher than current offers today.
“Ultimately, choosing a variable rate mortgage or a fixed rate mortgage really comes down to an individual’s preference and situation,” adds Sparrow. “So there’s really no definitive right or wrong answer.”