Compared to fixed-rate mortgages, variable-rate options cost less for the borrower — even when rates are expected to rise
By James Harrison
When you’re thinking about what kind of mortgage you need, you might be tempted to do what many Canadians do without giving it much thought: They choose a fixed rate.
Fixed-rate mortgages are the most common type of home loan. According to a report by Mortgage Professionals Canada, 72 per cent of Canadians who bought homes in 2016 or 2017 secured fixed-rate mortgages.
Especially when news media stories predict interest rate hikes in the near future, borrowers grasp onto fixed-rate mortgages. They’re willing to pay a rate premium in exchange for a consistent monthly payment and a feeling of certainty.
But they’re not doing themselves any favours.
The media hype around possible interest rate hikes is often inaccurate, and the fear is fuelled by banks who profit from locking borrowers in at the premium rates attached to fixed-rate mortgages. These loans are simply more profitable than variable-rate mortgages, so banks like to create the impression that a five-year fixed mortgage is the obvious choice.
The fact is, a variable-rate mortgage is almost always a better choice for borrowers who want to pay less for their loan. And that’s true even when rates are expected to go up.
Feeling the variable-rate jitters?
Many borrowers are feeling nervous now because the Bank of Canada has hiked the key interest rate five times since July 2017, from .50 to 1.75 per cent, and economists have predicted more raises in 2019.
Those nerves are understandable. But when you do the math, and when you know the history of how interest rates move in Canada, it becomes clear that a variable-rate mortgage can still save you thousands in interest payments compared to a comparable fixed-rate product.
Not only that, it’s possible to reduce the risk and maximize the benefit of a variable-rate mortgage by making strategic monthly payments that are a little higher than they need to be from day one.
But more on that smart strategy in a minute. First, let’s look at the reasons why variable mortgages are a better choice.
Why variable-rate mortgages cost less
Variable rates are typically lower than fixed rates. But the spread between the two types of mortgages can vary.
That’s because variable mortgage rates are tied to the prime rate. When the Bank of Canada’s prime rate goes up, variable mortgage rates follow. On the other hand, fixed mortgage rates are primarily influenced by the yield on government bonds of the same term. The two types of mortgage are influenced by different factors, so the spread fluctuates.
When rates for five-year fixed mortgages are at least 0.5 per cent higher than rates for comparable five-year variable mortgages, it makes more mathematical sense to choose a variable product.
The spread is important because when it’s 0.5 per cent or more, it’s extremely unlikely that rates will go up enough during the five-year term of a mortgage to make a variable mortgage more expensive than a fixed one.
We know it’s unlikely because we can look at how the Bank of Canada’s has historically adjusted its prime rate, which in turn causes variable mortgage rates to go up or down.
When the Bank of Canada implements federal monetary policy by adjusting the prime rate, it rarely does so quickly. It moves the rate up or down by 0.25 per cent with each adjustment, then it waits to see the effect on inflation.
As well, given historical trends, it’s extremely unlikely that rates will only go upward over the five-year term of a mortgage. They may go up for a while, but then they’ll go down again because of the cyclical nature of the economy.
We can apply our understanding of history and make some reasonable predictions about the future. Looking forward at the next five years, we see that while rates may go up a few times over the next two or three years, an economic recession is due in 2020 or 2021. Rate decreases are the federal bank’s likely response.
With the current spread between five-year fixed and five-year variable rates, the prime rate would have to go up by 0.25 per cent about seven or eight times over the next five years for you to start losing more with a variable-rate mortgage than you would with a fixed-rate mortgage. It would have to stay up, too, with no rate drops in between.
But that scenario is beyond imaginable for most people in the financial industry. If the prime rate were to go up — and only up — seven or eight times in less than five years, we’d be experiencing a widespread economic meltdown the likes of which we’ve never seen. It’s extremely unlikely.
The exception to the ‘variable is better’ rule
When we look at historical data, we can see the spread between fixed and variable mortgages is almost always greater than 0.5 per cent in Canada. Over the past decade, the spread has usually stayed between about 0.7 and 1 per cent.
There was a short period in 2016 when rates for fixed mortgages were low and the spread between fixed and variable was a mere 0.3 per cent. During that period, there was a strong reason to choose a fixed mortgage. But it’s extremely unlikely that we’ll see rates and spreads like that again anytime soon.
Why variable rate mortgages are more flexible
In addition to offering lower costs, variable rate mortgages allow borrowers more control and flexibility than a fixed mortgage.
In a variable mortgage, the borrower can break the mortgage at any time with only a three-month interest penalty. Compare that to fixed rate penalties, which are equal to either three-months interest or the IRD, or interest-rate differential calculation, whichever is higher.
For example, on a $500,000 variable-rate mortgage, the penalty for breaking it would be about $3,000 compared to a $20,0000 penalty on a comparable fixed-rate mortgage with a big bank.
No one plans to break a mortgage, but life happens. And avoiding a $20,000 penalty can make a dramatic difference in your life when you’re going through unexpected life changes.
In addition, a variable-rate mortgage allows you to lock into a fixed rate at any point. But it doesn’t work the other way. A fixed-rate mortgage cannot be changed to a variable one during the length of the term. You’re stuck with a fixed rate for the entire five years, no matter which way rates go.
How to reduce the risk of a variable mortgage
We suggest our clients choose a variable mortgage, but that they make monthly payments as if they had chosen a fixed one with a higher rate of interest.
That means they structure their household budgets in order to pay more than the minimum payment with each monthly payment. An extra $200 or $300 per month goes toward paying off principal instead of interest before rates have had time to increase. So the borrower saves thousands in interest over the life of the loan. And they pay down thousands more of the principal while they wait for any potential rate increase.
The strategy also builds in a buffer of three or four potential rate increases. Even if the prime rate goes up steadily for a year or two, the borrower is already used to a higher payment and their household budget is not affected by the rate changes.
In the 11 years I’ve been in the mortgage business, I’ve never once had a client regret going variable, but I’ve had many regret going fixed.
What to do if rates start to rise
The option to go fixed always exists for borrowers in variable mortgages. And when the news is full of predictions that interest rates are going up, clients sometimes call to ask about locking in to a fixed rate.
We never advise our clients to take the option of going fixed.
Instead, we suggest they increase their payments as if they did lock in. Or we suggest they break the current variable-rate mortgage and set up a new one with an even better variable discount.
What to look for in a fixed mortgage
As a licensed mortgage broker, I consider it my responsibility to explain the pros and cons of fixed-rate and variable-rate products. And I keep an eye on the spread, so I know I’m always giving up to date advice on which option makes more mathematical sense. But some borrowers will choose a fixed mortgage every time, no matter what the math indicates.
In that case, and also when the spread does drop below the 0.5 per cent mark, it’s important to choose the best possible terms for a fixed-rate mortgage, paying close attention to prepayment penalties.
While most borrowers have no intention of breaking their mortgage, about 60 per cent of Canadians do. So if you’re going fixed, you must look carefully at the penalties you’ll incur if you end up having to break it.
We recommend our clients choose non-bank lenders (also known as monoline lenders) when they do choose a fixed-rate mortgage. These dedicated mortgage lenders calculate IRD penalties differently than banks do. While banks use the posted rate to calculate the IRD, monoline lenders use a rate that’s an average of about 1.5 per cent lower. That means a significantly lower penalty when your loan is with a monoline lender.
How a mortgage broker helps
As a licensed mortgage broker, I help my clients get the mortgage that’s right for them by negotiating on their behalf with banks, credit unions, and other mortgage providers for the best rates and products. The cost of my services are free to home buyers. My fees are paid by lenders.
Interested in refinancing to reduce your mortgage costs? Call me to set up a free consultation.