Choosing between a fixed- or floating-rate mortgage never boils down to just one thing. But when the rate difference between the two is tiny, people often make it that way.
As the spread between fixed and variable rates shrinks, fixed mortgages seem cheaper relative to variables and can appear too good to pass up.
People figure, “Why risk a spike in prime rate when you can take a cheap five-year fixed and guarantee your interest costs for half a decade?”
But the fixed-variable spread is all too easy to misinterpret. If history is a guide, placing too much emphasis on it may very well cost you.
Beware today’s tight spread
The gap between five-year fixed and variable rates hasn’t been this narrow since the fall of 2016. Your average five-year fixed rate is now just one third of a percentage point more expensive than the average floating rate. If you’re getting an uninsured mortgage (required for a refinance, a 30-year amortization or home purchase over $1-million) the spread on the lowest rates is a razor-thin 0.16 percentage point.
But that doesn't mean you should pick a fixed mortgage.
This tight spread reflects market expectations of a dismal economy. Canada’s GDP contracted in December for the third time in four months. That’s not the type of performance that justifies higher rates. At this point, further monetary policy tightening could throw us right into recession.
That’s a big reason why the Bank of Canada on Wednesday watered down its pledge to raise rates.
It’s also why Canada’s widely watched five-year bond yield cracked below a key support level Wednesday of 1.74 per cent. It’s now down to levels we haven’t seen since 2017.
The overwhelming majority of economic indicators portends lower, or at least flat, interest rates for as far as the eye can see. Macquarie Capital Markets Canada is one of a growing number of economists that agrees, noting: “We believe the Bank of Canada has now reached its terminal rate of 1.75 per cent for this expansion.”
If rates don’t drop, they can go horizontal for quite a stretch. In the first half of this decade, they moved sideways for more than four years. That too is variable-rate friendly.
Even if the Bank of Canada surprised everyone and hiked a few more times, you’d still likely come out ahead with a competitive floating rate (currently 3.09 per cent or less) versus the typical five-year fixed rate (about 3.44 per cent). The economy is cyclical. If it can barely tolerate the rates we have now, it only reasons that higher rates would lead to a rate-cut cycle even quicker.
And one can’t forget the penalty advantage of variable rates, or the option to lock into a fixed rate without penalty at any time.
Quick Tip: If you think you might potentially lock in, get your variable mortgage from a lender that advertises deep-discount rates (variable and fixed) on its website. Otherwise, the lender could fleece you on the fixed rate when you ask them to convert.
Does this rule out fixed rates?
Valid reasons to go fixed include:
- Concerns about your ability to afford higher interest expense in the future (no one can categorically rule out higher rates);
- An overarching desire for peace of mind (there’s comfort in not caring about interest rates for five years);
- A great deal on a shorter fixed rate (watch two-, three- and four-year terms in the coming months; they’re due for hot deals);
The cost of “insurance” against rising rates – i.e., the extra you pay for a fixed rate – is the cheapest it’s been in more than two years.
Not coincidentally, the threat of inflation and higher rates is the lowest it’s been in more than two years.
All of this reinforces one thing: There’s abundant risk in using today’s narrow fixed-variable spread as an excuse to lock in.