Should you switch your variable-rate mortgage to a fixed-rate?
Canada Life - Jan 23, 2023
Is a fixed-rate mortgage the perfect fix?
What goes up must come down
With the recent Bank of Canada interest rate increase from 3.25% to 3.75%, and a forecast that suggests rates may continue to increase, many Canadians are worried. It’s important to remember that increasing rates aren’t permanent and won’t last forever. Rates increase in an effort to fight inflation. By slowing the economy, inflation will subside and eventually low interest rates will return to help re-stimulate the economy. The Bank of Canada predicts inflation rates should be back on target at 2% (currently they are 6.9%) by 2024.1
Although these percentage increases sound small, an increase as small as 1% for a variable-rate mortgage can mean thousands of dollars when spread across the year. Consider the following example:2
| Loan amount | Monthly mortgage payment at 5% | Monthly mortgage payment at 6% |
|---|---|---|
| $400,000 | $2,326.42 | $2,559.23 |
| $600,000 | $3,489.63 | $3,838.84 |
Although the first example with a loan of $400,000 represents an additional $232.81 a month, apply that over 12 months and you’re paying an additional $2,793.72 a year. This number increases to $4,190.52 a year for a loan of $600,000. Many Canadians don’t have the cashflow available to support such a significant additional annual expense.
As a result, many homeowners have some big decisions to make. Unless the Bank of Canada hits its inflation rate target earlier than expected, mortgage interest rates may continue to rise into 2023. The decisions homeowners make today about their mortgage won’t only impact them for the next few years but could also result in thousands of dollars in interest savings – or, thousands of dollars in extra interest payments.
To minimize the impact of future rate increases on your mortgage and your budget, you may be wondering if switching from a variable-rate to a fixed-rate mortgage is the solution.
Should you switch to a fixed-rate mortgage?
In recent years, variable-rate mortgage holders have typically saved money thanks to relatively low rates. However, as the Bank of Canada continues to increase rates, variable-mortgage rate holders have felt the effect.
How does the rate increase affect your mortgage payment? There are two types of variable-mortgages:
- Fixed payment – for these variable-rate mortgage holders, their payment does not increase with rising interest rates. Instead, more of their payment goes towards interest and less goes towards paying down the principal. What does this mean? It will now take you longer to pay off your home. This happens when the trigger rate is reached. The trigger rate is when the interest payment becomes more than the payment your mortgage was approved at. As the payment amount increases, it’s now only paying interest, so amortization is stretched out.
- Adjustable rate – for these variable-rate mortgage holders, their monthly payment increases or decreases are based on their lender’s prime rate (the interest rate major banks charge their clients). These mortgage holders have seen their monthly payment amounts continue to rise with the recent rate increases.
What is a fixed-rate mortgage?
Unlike variable-rate mortgages that are impacted by interest rate fluctuations, a fixed-rate mortgage stays the same throughout the entire term of the loan/mortgage contract, regardless of rising or declining rates.
Switching to a fixed-rate mortgage may seem like the perfect solution to combat the current challenges that come with having a variable-rate mortgage in a high interest rate economy. However, there is no clear-cut solution and there is a level of risk by switching to a fixed-rate or riding out your variable-rate mortgage.
Although everyone’s situation is unique, these key pros and cons can help you determine if switching to a fixed-rate mortgage may be a good fit for you.
| Pros | Cons |
|---|---|
| Potential to save money Locking in at the current interest rate can protect you from future rate increases and help you save money if rates continue to increase. | Potential to lose money If the Bank of Canada doesn’t increase interest rates further, or they decrease interest rates after you’ve locked in on a fixed-rate mortgage, you’ll lose money – you’ll continue paying your fixed rate regardless of interest rate changes. In short, you’ll have missed out on an opportunity to save some money as interest rates decrease. |
| Predictable payments Provides peace of mind by locking in a fixed rate or payment (for the remainder of the term) and removes the uncertainty that comes with future rate increases. | Locking in at a higher rate Although it may feel like you’re losing money on your variable-rate mortgage, switching to a fixed-rate mortgage now may actually cost you more. If you only have a couple years or less on your current term, it may make more sense to stay with your variable rate. Your variable rate likely saved you some money while rates were low. Locking in at a fixed rate now will guarantee that you’ll pay the current high interest rate for the remainder of your term. It might be worth waiting to see if rates lower in the near future. You need to consider if you’d rather lock in at the high rate right now or wait for the rates to come down. |
| Short-term fixed mortgage option Locking in for five years at the current high interest rate may not seem like an opportunity to save money. An alternate option may be to lock in on a short-term fixed mortgage rate. Banks tend to prefer a five-year fixed mortgage rate. The short-term fixed-rate mortgage may give you some flexibility at the end of the term when interest rates are hopefully lower (as the Bank of Canada anticipates they will be in the next couple years). Important note: to opt for a short-term fixed-rate mortgage you may face an interest rate penalty. | Additional costs Can you afford the increase as you switch to a fixed rate? The fixed rate you lock in at will likely be higher than the variable rate you’re currently paying. Although I can’t predict if your variable rate will rise higher than that fixed rate, its most likely that the fixed rate will cost you more in the short term. |
| Additional fees There may be potential fees when you switch to a fixed-rate mortgage or break your mortgage (if you want to switch to a different lender with lower rates). | |
| Higher penalty if you break mortgage If you need to break your mortgage agreement, fixed-rate mortgages tend to have higher fees. If you think you may need to break your mortgage agreement in the near future, switching to a fixed-rate mortgage could end up costing you more. There is typically a three-month interest penalty to break a mortgage. |
In addition to reviewing the pros and cons, there are also some key questions you should consider before switching to a fixed-rate mortgage:
- How would you feel if you locked in for five years at today’s high rate and rates dropped slightly in the coming year?
- Are you comfortable with the risk of a rate drop after locking in? Or, are you more comfortable with locking in to avoid the risk of another rate increase?
- How close are you to paying off your mortgage?
- How tight are your finances? Is it hard for your budget to cover your variable mortgage’s rising monthly payments? Is your financial situation affecting your emotional wellbeing?
How do you lock in a variable-rate mortgage?
To start the process of switching to a fixed-rate mortgage:
- Contact your mortgage specialist to see what their best fixed rate is. Ask if they’ll offer you a shorter term, like two years (inquire about additional fees that may come with a shorter fixed term). It’s also helpful to tell them you’re looking around for the best rate. They may be motivated to offer you a competitive rate. It’s important to shop around to find the best mortgage rate.
- Ask your specialist what the breakage penalty would be on your current mortgage (if you were to go to a different lender).
- Contact other mortgage lenders to see what the best fixed rate they can offer is.
Once you’ve gathered all the information about additional fees for a short-term fixed mortgage, breakage fees, and what the fixed rate will be, you may find the penalties don’t justify switching.
Make the decision that’s right for you
Remaining on a variable-rate mortgage or switching to a fixed-rate mortgage both carry a level of risk. The correct decision comes down to your personal financial situation and comfort level for risk. If high-interest rates are impacting your emotional well-being, causing significant stress or affecting your financial planning, switching to a fixed-rate mortgage may be the best option for you. However, if you can ride out the higher rates a bit longer, the risk may pay off in the coming years as the Bank of Canada predicts inflation will level off.
Contact your mortgage specialist or lender to determine which approach may work best for your specific situation.
I can help you adjust your financial plan, including your budget, to help meet today’s economic challenges. Contact me today to set up an appointment.