What do higher rates mean for your next mortgage?

Whether fixed or variable, higher mortgage rates means higher loan costs and this is particularly true after the Bank of Canada increased the overnight rate by 1% since the start of 2022. Based on this increase, a borrower with a $700,000 mortgage will now pay $359 more each month compared to a loan taken out in 2021.

These higher monthly mortgage payments are prompting many first-time buyers and those coming up for renewal to ask whether or not a fixed rate or a variable rate mortgage is better. Here’s how to decide.

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When to select a fixed-rate mortgage

For first-time buyers, getting a fixed-rate mortgage means less purchasing power but more certainty over monthly payments and overall interest paid on the debt.

This certainty is particularly helpful for buyers with high debt ratios—meaning the monthly mortgage payments eat up more of their monthly budget. While the Bank of Canada overnight rate only impacts variable rates that doesn’t mean fixed rates aren’t rising, as well. Fixed-rate mortgages are well known to be tied to the bond market.

With bond returns rising over the last few months banks have already begun to increase fixed rates to hedge against fluctuating bond yields. Since September 2021, fixed rates have risen by 1.8%, on average — adding another $640 per month on the mortgage payment of a $700,000 mortgage.

If extra mortgage costs would break your budget, then locking in a fixed-rate mortgage is a smart strategy.

Remember, shop around when looking for a fixed rate; it’s still a very competitive market and lenders compete aggressively for new business.

When to select a variable rate mortgage

Now, just because rates are rising, doesn’t mean a variable rate mortgage is a bad idea.

There are always a few scenarios when choosing a variable rate mortgage—even in a rising rate environment—is a smart strategy.

Scenario #1: You don’t plan to stay in the home for 5 years

While buying real estate is typically a long-term investment decision that doesn’t always mean that every buyer intends to stay in a property long-term.

If you know you’ll be leaving the property—either selling or changing the use from a primary residence to rental property—then choosing a variable rate mortgage makes sense.

As soon as you break a fixed-rate mortgage, you’ll need to pay a penalty that’s calculated using the Interest Rate Differential (IRD). While this calculation is different from lender to lender, it can be steep; some borrowers have reported paying $20,000 or even $30,000 or more in fees to break their mortgage.

Choose a variable rate mortgage, and you’d have the option of breaking your variable mortgage at any point and paying only a few months’ interest in pre-payment penalties.

Scenario #2: You plan to aggressively pay down your mortgage

Another good reason to select a variable rate mortgage is to capitalize on the lower monthly mortgage payment and use it to your advantage.

At the start of June, the best five-year fixed rate was 3.69%, compared to a five-year variable rate of 2.25%. On a $700,000 mortgage, these monthly mortgage payments work out to $3,565 versus $3,049.

After five years, the borrower with the fixed-rate mortgage would still owe $606,044 in mortgage debt. However, if they opted for the variable rate mortgage but paid the fixed-rate monthly payment, after five years they’d owe $556,728 (assuming no change interest during that time). That extra payment on the variable rate mortgage reduced your overall mortgage by almost $50,000 over the five-year term.

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What to expect moving forward

In the first half of 2022, Canada’s central bank has already raised its overnight rate by 1%, in an effort to cool inflation. According to Statistics Canada, the country’s inflation rate reached 6.8% in May 2022, the highest level in more than 30 years. As a result, the Bank of Canada has stated that it will continue to use the overnight rate to manage inflation and keep it between 1% and 3%.

In fact, Ian Lee, an associate professor at Carleton University’s Sprott School of Business, told CTV News that he expects the Bank of Canada to keep raising its policy interest rate to more than 3% by the end of 2023. As a result, he said it may be worth considering a fixed-rate mortgage since these borrowers are sheltered from any rate hikes until their mortgage is up for renewal.

However, those looking to pay down mortgage debt quickly, or those in more uncertain circumstances, can capitalize on lower variable rates. Historically, variable-rate mortgages offer lower rates, which translate into lower monthly mortgage payments. Using a prepayment plan borrowers can use these lower payments to their advantage and strategically reduce their overall borrowing debt and expense. Ultimately, the decision to opt for one type of mortgage over the other comes down to individual risk appetite.

If you’re worried about rising rates and prefer to know exactly what you’re paying each month, a fixed-rate mortgage is best. Fixed-rate mortgages provide certainty in knowing what you pay each month and rate hikes won’t impact you for the length of your term.

If you are more comfortable with taking on risks or have a plan to add extra payments to the mortgage, a variable-rate mortgage can be ideal. The lower monthly payment makes it easier to find room in your budget for extra payments; however, you will have to absorb any future rate hikes.


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About the Author

Romana King

Romana King

Senior Editor, Money.ca

Romana King is the Senior Editor at Money.ca. She writes for various publications, and her book -- House Poor No More: 9 Steps That Grow the Value of Your Home and Net Worth -- continues to be an Amazon bestseller. Since its publication in November 2021, this book has won five awards, including the New York CPA Society's Excellence in Financial Journalism (EFJ) Book Award in 2022.

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