This morning, July 11, 2018, the Bank of Canada increased its overnight rate by 0.25 per cent to 1.5 per cent. It was the first rate hike in six months, but bank’s fourth increase over the past 12 months.
The overnight rate — what major financial institutions charge each other for a one-night loan — is a trendsetter. It leads financial institutions to raise prime rates, which means Canadians will be paying higher borrowing costs on such products as variable-rate mortgages.
For mortgage shoppers, there is absolutely nothing to fear in this news. With a new prime rate of 3.7 per cent, we are still highly recommending variable mortgages to our clients.
We’re saying: Do not lock in, and do not take a fixed rate. Here’s why:
The average spread between a five-year fixed mortgage and a five-year variable mortgage is now around 1 per cent.
So the prime rate would have to go up by 0.25 per cent eight or nine times more for you to be paying more interest on your variable-rate mortgage over a five-year term, when compared to a five-year fixed-rate mortgage.
The rule of thumb is: If the spread between a five-year fixed and a five-year variable is 0.5 per cent or more, go variable.
Consider the penalties
It’s important to note that the penalty on a five-year fixed mortgage is, on average, about nine times greater than that of a variable mortgage.
The average bank penalty to break a five-year fixed is approximately 4.5 per cent of your outstanding balance. So, for example, on a $400,000 mortgage, that would be a penalty of $18,000.
Compare that to the $2000 penalty on a variable-rate mortgage. It’s a massive difference.
Pay down your principal
We recommend our clients take a variable mortgage, but that they make payments as if they went fixed. So an additional $300 or 400 a month goes towards paying off the mortgage principal and not to the bank in interest.
We help clients build a plan so they can save thousands and pay off their mortgages faster. And in our view, it’s still a no-brainer to go variable.
Banks will always recommend locking in. In times like these, they’ll encourage clients to take a fixed rate product. But did you ever wonder why?
It’s because fixed rate mortgages are very profitable for the banks. The five-year fixed product is one of the most profitable mortgage products ever sold. And with massive penalties, it locks the client in.
Since about 60 per cent of clients break their mortgages, it almost never makes sense to go fixed. None of them plan to break their mortgages. But it happens. And we don’t like to see our clients slapped with big penalties when they’re facing unexpected life changes, so we advise against fixed-rate mortgages.
Back when we had five-year fixed rates at around 2.59 per cent or lower, there was a good argument for locking in. But those days are now gone.
Speaking with an experienced mortgage broker can help you define and realize your financial goals amidst a changing economic landscape. Call or email me any time with questions you or your clients might have about mortgages.