Eitan Pinsky and his wife were still settling into their newly purchased $4-million home when the Bank of Canada raised its benchmark interest rate by a full percentage point to 2.5 per cent in mid-July.
For the Vancouver couple – who are among the estimated 53 per cent of Canadian homeowners with a variable rate mortgage – that translated into an increase in their housing loan’s interest rate.
“So we ended up increasing our payments a couple of days ago because if we didn’t do that, our amortization period would be longer,” says Mr. Pinsky, owner of Pinsky Mortgages, a Vancouver-based mortgage broker. “Now a lot of clients are asking us: What should they do with their mortgage?”
That’s the burning question today for Canadians looking to buy a home or refinance their mortgage. Until recently, it made financial sense for many homeowners and buyers to choose a variable rate mortgage. But with the shrinking spread between variable and fixed rates, many are starting to eye the latter – a development that has even inspired Canadian food franchise Pizza Pizza to offer a “fixed-rate pizza” deal that lets customers lock in the price of an extra-large, four-topping pizza for up to a year.
“The big decision facing people today is, ‘Should I lock in?’ " says Ross Taylor, a mortgage broker and owner of Ross Taylor Mortgages in Toronto. “But I think the more important question people should be asking is, ‘What’s the best mortgage for my particular situation and risk tolerance?’ "
Affordability is one factor that’s been affected directly by rising interest rates. A buyer who previously would have qualified for a $500,000 mortgage under the federally mandated stress test – which screens buyers’ ability to afford a mortgage at either the posted Bank of Canada five-year rate or at their contract rate plus two per cent, whichever is higher – may now be approved for about $50,000 less.
Because interest on variable rate mortgages is still lower than fixed, buyers today will qualify for a larger loan amount if they go variable. But that’s no good for risk-averse borrowers.
Mr. Taylor offers a solution: Sign up for a variable rate mortgage then switch to fixed after the deal closes.
“It’s a little workaround,” he says. “You can convert from variable to a fixed rate with the same lender without having to requalify.”
Getting a mortgage with a credit union may be another way to qualify for a higher loan amount despite higher interest rates. Allison Van Rooijen, vice-president of consumer credit at Meridian Credit Union, points out that credit unions are provincially regulated and not bound by federal stress test rules.
This allows for some leeway for qualifying mortgage applicants.
“Many credit unions have flexible options that can be offered to borrowers outside of the traditional stress test,” says Ms. Van Rooijen. “A debt service ratio shouldn’t make or break a mortgage decision in isolation of other factors.”
Whether they’re dealing with a credit union or another type of financial institution, borrowers need to confirm if they’ve received an actual pre-approval for a mortgage or merely a conditional approval.
With a pre-approval, the lender holds the rate and commits to the transaction. A conditional approval, on the other hand, gives borrowers a general idea of what they can afford but isn’t an actual commitment from the lender.
“Borrowers need to understand this before they start looking based on what they think they can afford,” says Ms. Van Rooijen, who notes that what homebuyers can afford these days can also shift when they’re selling a house that closes below the price they were expecting to get.
So, if interest rates continue to shift as well, should borrowers who currently favour variable rates rethink their choice of mortgage?
For those who want to safeguard against further rate increases but don’t want to commit long term to a fixed-rate mortgage, Ms. Van Rooijen suggests taking a look at a shorter-term loan.
“We’re seeing very favourable rates in the two- to three-year space right now, but borrowers need to determine where they see themselves when that term comes up for renewal,” she says. “Also keep in mind that if rates continue to remain quite high you would be renewing at that market rate at that point in time.”
James Laird, co-chief executive officer of loan comparison website Ratehub.ca, says historical data points to variable rate mortgages as the “lower cost way to go, almost every time.” At the same time, the availability of fixed-payment solutions allows borrowers to maintain the same regular payments – unless rates reach a point where the payments are no longer enough to cover the principal loan amount and the cost of borrowing – but with a smaller portion of payments going toward the principal.
“So while your payments don’t change, what changes is your payment duration – it goes on longer,” says Mr. Laird. “Some people look at this as a happy medium because they get the benefit of a fixed payment, at least for the current term.”
By comparison, homeowners who bought their residence on an adjustable rate mortgage would have seen their payments increase when the prime rate went up in July. However, their payments against the principal – and the amortization period – would have stayed constant.
Mr. Pinsky at Pinsky Mortgages cites two ways variable rate mortgage holders can stick to their amortization schedule: Bump up the regular payment amount or make a lump-sum payment.
“With many of our clients we suggest coming up with a lump sum of up to 15 per cent, which most lenders allow you to do as many times as you want, while some allow only once a year,” he says. “Many do choose to go this route as opposed to increasing their payments, because with a lot of lenders once you go higher [with regular payments] you can’t go back down.”
While rising rates have made it more important than ever for homeowners and buyers to choose a mortgage they can carry comfortably, now is also the time to map out a budget and financial plan that takes into account the possibility of even more increases in the near future, says Mr. Pinsky.
“Put some money aside or, if you can, secure a home equity line of credit as a safety net,” he says. “And if you do get a line of credit, don’t use it unless absolutely required.”
Ms. Van Rooijen agrees. In past years, borrowers tended to focus more on their debt repayment plan and not enough on budgeting and saving, she says. That’s not going to cut it with today’s higher rates.
“I would challenge borrowers to make sure, when looking at mortgage solutions, that they factor in all their day-to-day expenses – such as food and gas – in addition to the bigger expenses like maintenance and taxes,” she says. “Today more than ever, they need to have a co-ordinated debt and savings strategy that, among other things, ensures cash flow in an emergency – or in the event rates go up again.”