Ahead of Bank of Canada rate announcement: Choosing between long and short-term mortgages in a falling rate environment

#1. When is it better to select a fixed-rate mortgage?

It’s better to select a fixed-rate mortgage if you’re risk averse and don’t want to gamble on fluctuating rates and payments, explains Singh.

She adds that even mortgage professionals can be surprised by rate changes. “We didn’t expect them to go down as low as they [in 2020] did, but no one forecasted a global pandemic.”

When selecting the best mortgage option, Romana King suggests looking beyond your current and near-future needs.

“There are three main scenarios when a fixed-rate mortgage makes sense, even in a falling interest rate environment,” explains King.

Risk aversion

A fixed-rate mortgage offers stability if you’re risk-averse and do not want to deal with the uncertainty of fluctuating mortgage payments. Even though rates may be falling, locking in a rate ensures predictable payments over the term, which can provide peace of mind.

Budget constraints

A fixed-rate mortgage is a safer choice if you’re a homeowner working with a strict budget and cannot handle the potential for even short-term payment increases. With a fixed rate, you can avoid the risk of potential payment increases if market conditions change.

Long-term planning

A fixed-rate mortgage can be beneficial if you stay in your home for the mortgage term with no plan to sell or refinance until much later. This is especially true if they are content with the current fixed rates, even if variable rates could potentially fall further.

King adds, “A fixed-rate mortgage is better for homeowners who prioritize stability, need predictability in their payments, or have financial constraints that make dealing with variable payments more challenging. Even in a falling rate environment, these factors can outweigh the potential benefits of a variable-rate mortgage.”

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#2. When is it better to select a variable-rate mortgage?

If you’re comfortable with taking on more risk regarding mortgage payments, a variable-rate mortgage is a good option. That said, variable-rate mortgages are also a wise choice in the following scenarios:

• You are planning on moving before your mortgage contract ends;
• The mortgage lender does not allow you to port a mortgage (move to another property) and you want to avoid a significant penalty for breaking a mortgage;
• You are shopping for a mortgage on a rental property.
  

For instance, if you’re a first-time landlord, you may decide that owning and renting out property is not for you. As a result, you may opt to sell the property before the mortgage contract ends. With a variable-rate mortgage, the penalty paid for breaking the mortgage will be significantly less.

In general, the penalty for breaking a variable mortgage is the sum of three months’ worth of interest payments.

Compare this to the penalty for breaking a fixed-rate mortgage, where your lender will calculate the penalty based on the Interest Rate Differential (IRD) formula — resulting in a significantly higher penalty payment.

Variable-rate mortgages are also a good choice if you’re prepared to weather market shifts and their impact on your monthly finances.

But there is a downside to taking on this risk, explains Singh. “We saw many [homeowners] in variable rates over the last couple of years where their payments went too high too quickly, and they were forced to refinance or even sell.”

King explains that homeowners in a falling interest rate environment might prefer a variable-rate mortgage in the following six scenarios:

1. Expectation of further rate drops

If a homeowner believes that interest rates will continue to decline, a variable-rate mortgage allows them to benefit from these reductions as their mortgage payments will decrease with falling rates.

2. Short-term flexibility

Homeowners who plan to move, sell their property, or refinance within a few years may benefit from a variable-rate mortgage. These mortgages typically come with lower penalties for early repayment (usually just three months' interest), which can be significantly less than the penalties for breaking a fixed-rate mortgage.

3. Comfort with risk

If the homeowner is financially comfortable with the possibility of fluctuating payments and has a flexible budget, they may be willing to take on the risk of a variable-rate mortgage to take advantage of lower payments as rates fall.

4. Potential to lock in later

Some variable-rate mortgages offer the flexibility to switch to a fixed-rate mortgage later on. This allows homeowners to take advantage of falling rates now, while allowing them to lock in a fixed rate if they feel rates have bottomed out or they want more stability.

5. Higher current fixed rates

Sometimes variable-rate mortgages may have lower initial rates than fixed-rate mortgages, even in a falling rate environment. Homeowners who want to keep their payments low in the short term prefer this option, particularly if the rate difference between fixed and variable is significant.

6. Investment properties

For landlords or investors, variable-rate mortgages can be a good option due to the lower penalties for breaking the mortgage if they decide to sell the property early or need to restructure their financing.

King adds, “A variable-rate mortgage is better for homeowners who are comfortable with risk, seek short-term flexibility, or believe that interest rates will continue to drop. The potential to benefit from further rate reductions and lower penalties for early repayment are key advantages in this scenario.

#3. Given the current interest rate environment, how long should I lock in for a fixed mortgage?

That depends on your unique situation, Singh says. Lower rates associated with current five-year terms might be the only option available to you, as higher rates result in ratios not fitting within your lender’s approval range.

At this point, fixed-rate mortgages have lower interest rates than variable-rate mortgages, but the spread — the difference between the fixed-rate and the variable-rate mortgage — is marginal. Any additional rate reductions could bring variable-rate mortgage rates down further. Singh recommends choosing a variable-rate mortgage with a shorter term if you’re willing to take that risk, given the possibility of future rate drops.

Ideally, the Bank of Canada will drop rates one or two more times in 2024, giving variable-rate mortgage holders additional reductions in their mortgage payments.

However, if you’re risk-averse or unsure that variable interest rates will drop soon, locking in a five-year fixed-rate mortgage is a solid option. Singh advises finding a lender with a competitive five-year rate that also offers lower penalty calculations, should you need to break and refinance due to falling rates during your term.

“If you are more conservative but want an option, you can take the best five-year rate found (without fine print that can limit you) with a lender that offers a lower penalty calculation should you find the rates dropping within your term,” she says.

“This will allow you to break and refinance if the penalty costs are recouped with additional savings for the remaining amount of the term.”

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#4. Given the current interest rate environment, how long should I lock in for a variable mortgage?

If you’re seeking a competitive variable-rate mortgage in 2024, the best rates are typically found on three- to five-year variable-rate terms. This allows you to take advantage of lower payments while maintaining the flexibility to switch if needed.

Additionally, the penalty for breaking any variable-rate mortgage is only three months’ interest payments. A variable-rate mortgage now can also give you the option to lock into a fixed-rate mortgage later without heavy penalties.

A variable-rate mortgage could be a great option if you believe rates will continue to trend downwards in 2024, as some experts predict. If rates do drop, you could switch to a lower fixed-rate mortgage later.

However, as Singh warns, variable rates are currently higher than fixed rates, and there’s no guarantee rates will drop, so variable-rate holders may end up paying more.

#5. What are the important factors to consider before selecting a mortgage term?

According to Singh, the single biggest factor is your budget. The mortgage payment needs to fit comfortably within your budget and lifestyle. Ratios and calculators can help, but ultimately, it boils down to what you can afford and absorb.

Before deciding, homeowners should consider what they qualify for in today’s rate environment and their ability to handle potential payment increases, make extra payments, or absorb penalties for breaking a mortgage early.

For homeowners struggling to determine the best option, Singh recommends answering the following questions:

• Can I afford increases to my monthly mortgage payment if rates fluctuate? For instance, could my budget absorb a 1% increase in my mortgage rate (a situation that occurred in 2023)? Will my finances be OK if the balance owing at the end of my term is higher than I expected? Will my financial goals get derailed if I’m forced to extend my amortization — the total length of time to pay off the mortgage debt?
• Do I have the ability to make additional payments if the funds are available, either as lump-sum or as ongoing mortgage pre-payments?
• Can I absorb the penalty required to break my mortgage to lock in at a lower rate?
• Will I shop for a better mortgage rate and go through the process to confirm rates, apply for a new mortgage and pay the penalty to secure the new rate? Or am I the type of person who would rather put off comparison-shopping mortgage rates for as long as possible?

#6. I’m a single-income family. Should this be a factor when I select a mortgage type and term?

Absolutely, says Singh.

Single-income families are more challenged with the higher rates in 2024. While shopping for a competitive rate is a challenge, single-income homes are also challenged when it comes to qualifying for a new mortgage. Often, this means that single-income households are forced to work with their pre-existing lender — and this can mean missing out on the most competitive mortgage rates.

Another factor that can impact how aggressively a homeowner can compare rates and mortgages is the type of income earned. Self-employed people or those with fluctuating incomes, such as contract workers, will have a challenging time compared to full-time salaried employees, says Singh.

To make the best decision, consider how and where your income is coming from, says Singh. For instance, if you’re nearing retirement or have any other foreseeable changes to your income, discuss these factors with a mortgage professional. Armed with this information, a mortgage broker can help you find a mortgage rate that fits your current budget and helps you avoid unnecessary costs or hardship in the future.

#7. What are the downsides to a long-term mortgage contract in a falling-rate environment?

It really depends on your lender, says Singh. The big six banks and other lenders use the IRD, which, though sounding the same as other lenders’ posted rates, is different.

“Though the name is the same as the lenders who do not have posted rates, the penalty calculation is drastically different,” Singh explains.

“Though both types of lenders use the term IRD, some have posted rates, which they have discounted for you to get to your contract rate. When breaking these mortgages, you must add that discount rate to the difference in the previously mentioned calculation to determine your overall IRD. This can be quite a bit different for a mortgage of $500,000, for instance.”

Why is that IRD the big downside to a long-term contract in a falling-rate environment? Because your fixed rate means you’re locked into that rate. If rates drop and that IRD is high, you’re missing out on benefitting from that rate drop for the remaining term of your contract.

#8. What are the downsides to a short-term mortgage in a falling-rate environment?

The biggest downside to a short-term mortgage in a falling rate environment is that the rate to lock in that mortgage term is higher than what you’ll pay for a longer-term contract. This means your payments will be higher.

It’s also hard to know which of the shorter-term contract terms is the best choice.

“What is the best short-term? One year, two years or three years? We won’t know until after the rates go up,” says Singh. And none of us have a crystal ball.

In a falling rate environment, there’s no crystal ball telling us when rates might start to creep back up.

“For instance, if you take a three-year term but the rates drop to the lowest after a year and start to come back up, you are still locked in,” explains Singh. “So the penalty is still a component if you had to break even in this shorter term. A one-year term is a higher rate for the most part as well. So it comes down to each family’s comfort level on risk and their budget.”

#9, What prediction do you have for interest rates for the remainder of 2024? And going into 2025?

We all wish we had a crystal ball, says Singh. Still, most mortgage brokers, including Singh, believe that rates could still trend downwards for the remainder of 2024 and going into 2025.

However, Singh warns that homeowners should temper their expectations.

“I would be shocked to see rates fall to less than 4% again,” says Singh. Unless, of course, there’s another COVID-type global event.