A new environment
Often, the appeal of variable-rate mortgages is that the initial interest rate is considerably lower than what’s attached to comparable fixed-rate loans.
Even though the interest rate can vary during the loan term, rising or falling depending on the Bank of Canada rate, borrowers opting for variable rates bet that whatever increases they experience won’t be so steep as to make their mortgage more expensive than what a fixed-rate loan would cost them.
Historically, they’ve usually been right, says Chris Turcotte, president of Centum Financial Group.
“Price-wise, there are very, very few instances over the last 25 years where you've been better off being at a fixed [rate],” Turcotte says. “The variable is traditionally always lower.”
But history provides little guidance or comfort in unprecedented times. Home buyers considering a variable mortgage in 2022 will likely have to reckon with multiple rate increases this year, depending on how aggressive the Bank of Canada is in its battle against inflation.
With that uncertainty in mind, the predictability of a fixed-rate mortgage may still be worth paying a premium for. But in order to make the most informed decision possible, it’s important to understand what both fixed and variable mortgages offer when rates are creeping up.
The cost of an aggressive Bank of Canada
Prior to the end of 2021, analysts were expecting three or four rate hikes from the Bank of Canada this year. But with inflation reaching a 30-year high in December, markets are currently pricing in as many as five increases for 2022.
Scotiabank says an unusually aggressive Bank could raise the overnight rate from its current level of 0.25% all the way to two per cent by year end, which would imply seven increases of 0.25%.
Fixed-rate borrowers have little to fear from the moves. Their mortgage rates are guaranteed not to change until the end of their term.
But fixed-rate mortgages today come with considerably higher rates than the variable mortgages on offer. That means paying more interest. Whether the certainty of knowing how much your mortgage will cost you every month is worth the extra expense is a decision only you and your financial advisor can make.
What will multiple rate increases cost variable borrowers?
Each time the Bank of Canada increases its overnight rate, variable mortgage rates rise by the same amount. If you scored an incredibly low variable mortgage rate of 0.99% in January, a one percentage point increase in the BoC’s rate would bring your mortgage up to 1.99%. On a $500,000 mortgage with a 25-year amortization, your mortgage payment would grow by $225 a month.
If you’ve been in a variable mortgage since the beginning of the pandemic, the savings you’ve enjoyed while rates were low will take some of the sting out of such an increase.
But borrowers with more recent mortgages, or those considering a switch from their current fixed-rate loans, may not get the same opportunity to capitalize on the gap between variable and fixed rates before it begins narrowing.
Saskatoon-based iSask Mortgages broker Chris Kolinski suggests that variable-rate borrowers voluntarily increase their monthly payments at the outset of their loans, typically to the amount they’d be paying if they agreed to a fixed-rate mortgage.
The higher payments help you pay down your mortgage faster at the beginning of your loan, when compounding interest costs borrowers more, and can protect you against future interest rate increases.
“When rates rise, you can keep your payment the same,” Kolinski says. Rates would need to rise significantly to impact the savings created by paying down your principal faster, he adds.
Breaking your mortgage
Breaking a mortgage, or changing its terms before the end of a loan agreement, is common in Canada. People sell early, they move, they get divorced. Some estimates say as many as 60% of Canadian borrowers break their mortgages.
Breaking a mortgage is legal. Lenders understand that life is unpredictable and will generally work with you to make changes to your mortgage contract. But they’ll also charge you for the privilege.
The penalties charged to break a contract are among the biggest differences between fixed-rate and variable mortgages.
With variables, the penalty is three months’ interest. Some fixed-rate loans can also carry modest breakage penalties, but others can cost homeowners tens of thousands of dollars, depending on the lender and the terms of the mortgage.
Turcotte has seen rate-obsessed borrowers get themselves into trouble by signing fixed-rate mortgages that carry the prospect of paying brutal penalties.
“A rate that’s 0.05% lower might save you $600 over the term, but then you end up paying a $40,000 penalty when you decide to move,” he says. “You’ve got to zoom out and look at the big picture.”
There are products out there for borrowers who want the flexibility of a variable mortgage with the stability of a fixed rate.
John Vo of Spicer Vo Mortgage in Halifax says some lenders offer variable rate mortgages where, instead of increasing your monthly mortgage payment, a rise in the overnight rate is met with an increase in your amortization period. Your mortgage will last a little longer, but your payments won’t change.
To hedge against the financial impact of a longer amortization period, Vo suggests his clients make bi-weekly, rather than monthly, payments, a strategy that can help shorten a loan term.
“Typically, it'll reduce our amortization by about a year and a half or so,” Vo says.
You could also opt for a 20-year amortization schedule for your mortgage, which would offset any term-lengthening that might come from choosing a variable mortgage of this kind.
“It would take something drastic, like hyperinflation, to make me sign a fixed-rate mortgage again on my personal mortgage,” Kolinski says. “I just re-signed a variable and I am planning on weathering all the future rate increases.”
But what’s right for one homeowner isn’t necessarily right for you. Whichever type of mortgage you wind up choosing, your decision has to be based on what your finances will support across different scenarios.
Even though fixed-rate and variable are the two main categories of home loans, each one contains a variety of mortgage products to choose from. A good mortgage broker will take the time to explain what the different options could cost you over the long and short terms.
Simply put, don’t ask “fixed or variable?” Ask “what’s the best mortgage for me?”
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