With the latest Bank of Canada interest rate announcement just days behind us, a lot of people are questioning when the next rate increase will happen – if ever.
Towards the end of 2018, many were expecting interest rates to rise for the foreseeable future. That was based on the long period of low interest, the American Federal Reserve slowly but steadily increasing their rates, and the relatively strong Canadian economy, among other factors.
But the thoughts of increases turned to thoughts of cuts in a matter of a few months. Now many are wondering if there are going to be interest rate cuts in our future, despite the earlier pressure to raise rates.
If you have a variable rate mortgage, you’ve probably breathed a few sighs of relief over the past few months as the Bank has kept interest at 1.75% since October 24, 2018. That means your interest payments have also remained the same, giving you plenty of time to take advantage of your lower variable rate when compared to a fixed mortgage.
On the other hand, if you have a fixed-rate mortgage you’ve probably been keeping an eye on the movement of interest rates just to see what kind of rate you might expect when you need to renew your mortgage. Fixed rates never cost more for the length of the mortgage, no matter what the Bank of Canada does to interest rates.
So now that variable rates have stagnated for half a year, is now the best time to get a variable mortgage? Let’s discuss.
Variable rates, unlike fixed rates, are advertised as “Prime minus X%,” where X is your prime discount. Prime changes whenever the Bank of Canada adjusts interest rates, but your prime discount will always stay the same. This way, lenders don’t have to update their prices when prime changes.
For example, right now prime rate is 3.95% and the best mortgage rate in Canada on RateShop.ca is 2.90%. That’s actually prime minus 1.05%. If the Bank of Canada were to raise interest rates by 0.25%, your new interest rate would be 3.15%. That’s because your discount remains constant, but prime went up. You would then subtract your prime discount from the new prime rate, which would give you 3.15%.
One of the biggest reasons to choose a variable mortgage over a fixed one is to take advantage of lower rates.
Variable rate mortgages almost always have lower interest rates than fixed rates. The caveat here is that there’s a chance that rates may increase to more than a comparable fixed rate mortgage. Fixed rates charge a premium to ensure that your payment will never increase.
If you get really lucky, your variable rate mortgage will go down over time – or at least, won’t go up. This is the best case scenario for a variable mortgage because you get the benefit of a lower rate without ever having to pay more than a fixed rate.
Contrary to popular belief, your payment doesn’t actually go up when prime increases. Instead, most lender will just adjust the portion of your payment that goes towards interest. This will mean you pay more in interest every month but your actual payment amount stays the same.
There are some lenders that will adjust your payment as prime increases or decreases, and in those cases the portion going to interest will remain the same as your payment changes.
Since your payments on a variable rate mortgage don’t automatically increase when prime does, you’re actually extending your amortization slightly when you don’t adjust your payments accordingly.
For small increases, it may not make much of a difference, but for larger rate increases you could substantially delay your final date of mortgage freedom, if you stay in your house for that long.
Increasing your payment even if you don’t have to may be a good idea to keep your amortization on track. It will also reduce the total amount of interest you pay. When your mortgage payment is adjusted for a prime rate increase, the amount of money going towards your principal is decreased. That leaves more money per month that accrues interest, and that can add up over time.
Don’t forget that interest is front-loaded with any loan. In other words, your monthly interest payment is most expensive right at the beginning of a loan, and is very small at the end of a loan.
To demonstrate, imagine you have a $10,000 car loan with a term of 5 years at 5% interest. If you make a $1,000 one month after starting the loan, you’ll save $262 in interest over 5 years. If you instead wait to pay off the last $1,000 in a lump sum, you’ll only save $24 in interest!
As you pay off your loan, you’re also reducing the principal amount remaining. Your interest payment is determined by how much money you owe, so reducing the amount quickly will save you more money in the long run.
If rates go up, the best time to make extra payments is right away, as you take advantage of the lowest interest rate right at the beginning of the mortgage. If rates go down, the best time to make extra payments is still right at the beginning, since that’s when you’re financing the most money.
The interest rate on a mortgage is very important, but it’s not the only thing that you should worry about when buying a home. Something else to consider is the penalty for breaking your mortgage early.
Many Canadians believe that they won’t break their mortgage and will stay in their house for years, if not the rest of their lives, but that’s not always the case. In fact, a majority of people break their mortgage contracts, whether it’s to move, downsize, or refinance.
Breaking your mortgage comes with fees that can’t be avoided. The only way to pay off your mortgage without any penalties is to get an open mortgage, but those come at much higher interest rates and are only useful for when you carry the mortgage for a short time.
Most lenders use a penalty for fixed mortgages called the Interest Rate Differential. If your mortgage balance is especially high, the IRD can cost thousands of dollars. You can read more about IRD here.
For variable mortgages, the standard penalty is just 3 months’ of interest. This will usually work out to 1 + ½ months’ payments, since interest accounts for about half of your mortgage payment for the first few years of your mortgage.
The potential for savings in penalties is huge if you are a new homeowner who hasn’t had time to pay down their mortgage balance yet, or if you took out your home equity recently.
Variable rate mortgages aren’t perfect for everyone or every situation, mainly because of the potential for increasing rates.
Mathematically, it is often better to take a variable rate mortgage. Even if rates do increase to more than a comparable fixed year rate, you would have already saved money for the time the interest rate was lower. We know that interest is front-loaded, so that means it’s still better for you.
Not to mention the 3 months’ interest penalty is superior to the IRD penalty. It’s always better to pay less.
But the penalty savings only matter if you actually do break your mortgage early. And it’s possible for rates to increase almost immediately after getting a variable rate mortgage, meaning you don’t have time to enjoy the lower rate.
But the biggest downside of a variable rate mortgage is psychological. If you’re constantly worried about rate increases or are stressed at the idea of possibly paying more, then you shouldn’t get a variable rate mortgage. A mortgage isn’t worth stressing over.