January 24th 2024 Announcement: Bank of Canada Holds Rates

Is it time to consider a variable rate once again?

With the recent Bank of Canada decision to hold rates and indication of rate cuts in 2024, it might be a good time for existing homeowners to reconsider a variable rate mortgage when renewing or looking to make a change to their current mortgage.

This is particularly relevant given the past two decades of variable rates outperforming fixed rates, offering homeowners both flexibility and savings.

To assist you in making an informed decision, below are the insights into the differences between variable and fixed rates, along with the advantages they can bring in a declining rate market.

How Does A Variable Rate Differ From A Fixed Rate

1. Payment:

• Fixed-rate mortgages have a consistent monthly payment, while a variable-rate mortgage will fluctuate with the change of a lender's prime rate, which causes one of two things to happen:
• Adjustable rate mortgage: The monthly mortgage payment will increase or decrease with rising or falling interest rates.
• Static, fixed rate, variable mortgage: The payment stays the same even when rates fluctuate, but when rates increase, more of the amount goes to interest, extending the time to pay back the mortgage, and vice versa.

2. Penalties:

• Breaking a mortgage contract early before the term expires will require a “prepayment penalty” to the lender.
• A variable rate mortgage usually has a 3-month interest rate penalty.
• A fixed-rate which is the higher of 3-month interest or the Interest Rate Differential (IRD) calculation. Each lender calculates their IRD differently, but those penalties can greatly differ and be much higher than the penalties for variable rates.

When is a variable rate beneficial:

• Decreasing interest rates: Variable rates can offer cost savings when rates are dropping, expected to drop in the future or will be staying low for some time.
• Changes to homeownership: Lower penalties can benefit those who plan to move homes or refinance their mortgage before their contract term is up.
• High tolerance for rate fluctuations: Borrowers who are comfortable with a certain level of risk and can handle a fluctuating rate.
• When qualification rates are lower than fixed rates: Borrowers may experience more flexibility in their budget by qualifying for a higher mortgage amount with a variable rate.
• When the interest rate is lower than fixed rates: Historically, variable rates typically start lower than fixed rates. Even with potential future rate hikes, the initial lower rate can help borrowers meet the required stress test requirements.

When is a fixed rate beneficial:

• Rates are low and expected to rise - You will receive protection from future rate hikes.
• Economic uncertainty - Can shield borrowers from the impact of interest rate movements.
• Risk aversion - Risk-sensitive individuals may prefer a consistent payment each month.
• For long-term homeownership: For those who plan to stay in their homes for an extended period, a fixed-rate mortgage aligns with their commitment to long-term homeownership.
• For those focused on long-term financial planning - A better option for those who prefer long-term predictability for their finances.

Why did people stop taking a variable rate in 2022?

(Source: Edge Realty Analytics, The Edge Report December 2023)

Between 2007 and 2022 (except for 2019), the five-year variable interest rate was lower than the fixed rate. However, when the Bank of Canada rate started to increased the rate, variable-rate mortgages eventually became higher than the fixed-rate options, making short-term rates the preferred choice.

Challenges today with variable rates

• Higher qualification requirements than fixed rates - The” stress test” requires borrowers to qualify on the contract rate offered by the lender plus 2% or a rate of 5.25%, whichever is higher. With variable rates above fixed rates last year, qualification has been more difficult for those seeking a variable rate option.
• Higher payments than fixed rates - As rates increased, payments for variable options became higher than fixed options causing borrowers to switch to shorter-term solutions, hoping rates will soon drop or become more stable before their renewal date. Many of those homeowners today are facing renewals at much higher rates than if they had locked into a fixed rate earlier.
  

Opportunities for homeowners as rates decline with variable rates

• More flexibility and reduced interest payments if the prime rate decreases.
• Lower penalties if changes to the mortgage are required before the term is up.
• When rates start to decline again, variable rates have the potential to eventually drop lower than fixed rates.

Opportunities for homeowners as rates decline with fixed rates

• Those prioritizing long-term predictability may still want hte security of a fixed rate option.

Making A Decision:

It’s important to consider your financial goals, risk tolerance, and the potential impact of changing interest rates on your mortgage payments. You should also evaluate the cost savings against the risk of interest rate increases and explore payment strategies with your mortgage broker before making a decision:

• Anticipating Changes: What will the cost savings be during the ownership period, especially if you plan to sell or refinance before potential rate increases.
• Timing The Market: If there is a strong expectation that interest rates will decrease, you might want to take advantage of potential cost savings with a variable rate.
• Hedging With Low Rates: Taking advantage of lower rate periods to accelerate mortgage payments can reduce the overall effect of future rate increases.
• Building A Financial Safety Net: Creating an emergency fund can help protect you in the event unexpected rate increases cause higher payments for longer.
• Regularly Reviewing and Adjusting: Setting up quarterly or annual meetings with your mortgage broker to determine the next rate movements and making adjustments that equate to the lowest cost of borrowing.

As your mortgage professional, it’s my job to help you make the right decision when evaluating your finances and running mortgage scenarios for you. Let’s get started today to see if moving into a variable rate option will save you money.