The safe and sound choice in today’s mortgage market is to lock down a rate for five years and let borrowing costs do what they may.
That’s how you should proceed if you’re a nervous first-time home buyer or just holding things together financially as you renew. Everyone else, consider the variable-rate option. While they leave you exposed to rising interest rates ahead, variable-rate mortgages can be cheaper in two important ways.
Currently, widely available discounted variable-rate mortgages can be had for 2.4 per cent while fixed-rate mortgages bottom out around 3.19 per cent. That’s a maximum spread of 0.79 percentage points, enough to offset three increases in the Bank of Canada’s trendsetting overnight rate. The central bank could conceivably raise rates by more than 0.25 of a point in any one rate setting, but that’s unusual.
Variable-rate mortgages can also be cheaper than fixed-rate mortgages in the cost to break your loan before the term is up. People who demand the flexibility to exit a mortgage early at no cost can choose an open mortgage, but the cost is an extra-high mortgage rate.
Breaking a mortgage is fairly common. RateSpy.com says discussions with lenders suggest that only a little over half of borrowers with a five-year mortgage reach the end of their term, and that 15 per cent to 20 per cent of borrowers pay a penalty when breaking their mortgage.
Depending on when you bought a house within the past five years and your loan particulars, the penalty to break a fixed-rate mortgage with $400,000 remaining on it could cost roughly $2,500 to $5,000.
“A lot of people say they’re not going to make any changes during their mortgage term,” said Kola Ifabumuyi, a mortgage planner who reports that more than 90 per cent of his clients are going with a variable rate these days. “But many will break their mortgage.”
People break mortgages and pay penalties because they’re divorcing, they’re swamped by debt and need to refinance, they want to pay off their loan early or they’re selling and moving somewhere else. A mortgage might or might not be portable in a way that lets you move it to another home.
You could say that a variable rate mortgage is an insurance policy against upheaval or change in your life. If you needed to sell for some reason, you know that your penalty will be equivalent to three months of interest.
With a fixed-rate mortgage, you pay the greater of three months of interest or what’s known as interest rate differential. The IRD is to compensate your lender for interest lost because you exited your mortgage early. Banks are particularly tough in how they calculate the IRD, while some alternative lenders go easier on clients.
Depending on the rate environment, variable-rate mortgage penalties can be much lower than the IRD. Mr. Ifabumuyi is an advocate for variable-rate mortgages for this reason, and because he believes they will cost people less in total interest over the full life of the mortgage than they would with a fixed-rate mortgage.
The latest annual state of the mortgage market report by Mortgage Professionals Canada (representing mortgage brokers) found that of the homes purchased in 2016 and 2017 with a mortgage, 72 were fixed-rate, 24 per cent were variable and 4 per cent were a hybrid of fixed and variable.
This breakdown reflects the common view that in a rising-rate world, variable-rate mortgages aren’t the sure bet they once were for saving money on interest. “You’re hopping on the interest-rate roller coaster before it’s at the top, and that might not mean much savings in the long run,” said mortgage broker Ben Sammut, who favours fixed-rate mortgages right now.
There’s no doubt that variable mortgages expose you to rate risk. Your costs are lower today, but they could rise as far as the current higher-rate trend takes them. You can always lock into a fixed rate later on, but timing that right won’t be easy.
Think about lifestyle as well as finances when choosing a mortgage. If there’s a serious chance you’ll break your mortgages, the penalty in a variable-rate mortgage is simply calculated and often much cheaper than a fixed-rate mortgage. There’s value in having that flexibility, but only if your finances can withstand higher interest rates.