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A house for sale in Toronto, on Oct. 26.Eduardo Lima/The Globe and Mail

Soaring interest rates are bringing to the forefront a thorny personal finance question: How much room do you need in your budget to go variable on a mortgage?

An oft-quoted 2001 study by York University finance professor Moshe Milevsky shows that from 1950 to 2000, variable mortgage rates beat out fixed mortgage rates 88 per cent of the time when it comes to saving on borrowing costs.

But after six consecutive interest rate increases by the Bank of Canada, today’s environment may turn out to be more like the 12 per cent portion of history when variable rates did not come out on top, Prof. Milevsky told The Globe and Mail.

See how rising interest rates will affect the cost of your mortgage

Still, Canadians haven’t given up on variable rates – as of August, floating rate mortgage originations were still elevated compared with pre-COVID levels, according to a report by housing analyst Ben Rabidoux. Should rates start to decline in the next few months, Canadians choosing a variable today may be better off. But borrowers pondering a variable rate should always ensure they’d be financially okay even if their timing turned out badly. How to do that, though, is far from straightforward.

Mortgage brokers often recommend that borrowers who choose a variable rate have plenty of wiggle room in their budgets to be able to afford some interest rate increases. The interest rate on a variable-rate mortgage generally tracks movements in the Bank of Canada’s trendsetting policy rate. With fixed-mortgages, on the other hand, the interest remains the same for the term of the mortgage loan, usually between one and 10 years, giving borrowers more time to adapt to an environment of rising rates.

But the central bank’s slew of recent interest rate hikes raises the issue of what exactly is an appropriate amount of budgetary wiggle room. The policy rate has climbed from 0.25 per cent in early March to 3.75 per cent. The rate hikes went further – and happened faster – than economists expected at the beginning of the year.

On a mortgage with a balance of $380,000 – roughly the average borrowed by first-time homebuyers in 2020 and 2021 – those rate hikes mean a cumulative payment increase of nearly $745 a month for some borrowers.

And while most Canadians have variable-rate mortgages that come with payments that would normally remain fixed even as the interest changes, some of those borrowers are also feeling the financial squeeze. That’s because those loans are starting to reach their so-called “trigger points,” a threshold at which regular monthly payments no longer cover the interest owed and lenders often start to demand bigger payments.

One possible approach for prudent borrowers might be to look at the long-run average of the prime interest rate, the benchmark lenders use to set rates on variable-rate loans, said David Field, a certified financial planner and founder of Papyrus Planning.

Borrowers could aim to set aside for mortgage costs an amount equal to the payment they’d face if they had an interest rate equal to the historical average of the prime rate, Mr. Field said. If their actual mortgage rate is below that, they could use the surplus cash to make mortgage prepayments and hammer down their principal faster. If they hit their prepayment limit, they could save the extra in a savings account that could serve as a reserve fund they’d be able to tap if rates rose beyond the historical average, he added.

But with home prices as elevated as they are today, only higher-earning borrowers would be able to afford such a strategy in Canada’s priciest markets, Mr. Field noted. “It’s not a middle-class thing,” he said.

The monthly average of prime rate levels dating back to the start of 1960 is around 7 per cent. By comparison, current five-year variable-rate mortgages are in the 5-per-cent range.

Prof. Milevsky recommends borrowers put their finances through a broad stress test when choosing between a fixed and a variable rate.

If you had a large down payment and relatively small mortgage or you’ve already made good progress paying off your principal, you’re less sensitive to interest rate increases, he noted. Having a stable, predictable income also makes it easier to tackle rising borrowing costs, he added.

“It’s risky to go variable without access to a minimum of four to six months of cash for living expenses,” said mortgage strategist Robert McLister. “The last thing you want is for rates to go through the roof – as they did this year – and then you get hit with emergency expenses or income loss as your payments are going up.”

The financial fitness test for a variable-rate mortgage is a bit of a check-the-box exercise, as Prof. Milevsky describes it. If you check most of the boxes, you’re a good candidate for a variable rate, he said.

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