Don't get hosed when locking in a variable rate

Variable mortgage rates are looking more like GIC savings rates these days, hovering as low as 1.64% for an insured five-year term.

A rate that low is tempting. Even if prime rate surges a whole percentage point in a few years, you’re still in the historically low 2% range.

And at the first sign that rates may start rising, floating-rate borrowers can always lock into a fixed rate at any time.

But locking in isn’t quite that simple.

Converting to a Fixed is no Slam Dunk

First, nobody can perfectly time mortgage rates. Not even those whose livelihood it is to track them.

Bond yields, which largely determine fixed mortgage pricing, typically rise well before the Bank of Canada is ready to hike rates. As a result, fixed rates increase prior to prime rate, and often without notice. For a layperson, the chance of knowing exactly when to make the jump from variable to fixed is slim to nil.

Second, you're at a disadvantage when calling up your lender and asking to lock in.

• They know you want to convert for a reason.
• If rates are surging, they know you may be desperate.
• They know you don't know what rate you're eligible for.
• And they know you must pay a penalty to leave if you don’t take their rate.

Consequently, most lenders are in no hurry to offer you the best rates available to brand new borrowers.

Often, those who convert are offered standard advertised rates or an unpublished “conversion rate,” which can be as much as one-quarter to one-third of a percentage point higher than the lender’s lowest mortgage rate.

A quarter-point premium costs you $3,500 extra interest on a $300,000 mortgage over five years.

Mitigating Ugly Conversion Rates

You could always tell your lender to stick their pitiful conversion rate where the sun doesn’t shine. But that will cost you, too.

As an example, suppose you have a:

• $300,000 mortgage
  • Which isn’t far from the average mortgage of $278,300, per Q1 2020 data from TransUnion
• Typical three-months' interest penalty to break your current mortgage
  • Using back-of-the-napkin math, that’s $300,000 x 0.0245 (prime rate) / 4 = $1,837.50
  • Note: We assume prime rate in our formula because some lenders use it to calculate their penalties, even though the borrower may have a discount from prime rate
  • You need to divide the annual interest estimate ($300,000 x 0.0245) by four — because three months is one-fourth of a year
• Modest discharge/switch fee of $250

All told, the cost to break your floating-rate mortgage and convert to a fixed rate could easily add 0.15 to 0.20+ percentage points onto your new rate (or $2,100 in this example).

You can figure out the actual amount in your case by using a rate comparison calculator.

What’s Plan B?

If you find your lender isn’t willing to play ball and give you a good conversion rate, you’ll have to compare the cost of leaving.

If it’s only a few hundred bucks, it probably isn't worth your time. If it’s $1,000 or more, it might be.

Switching to a new lender can sometimes also get you:

• better terms, which are just as important as minor rate differences
• better features, like a home equity line of credit (only, if you need one)
• a cash rebate (some lenders are doling out up to $3,000 cash back depending on loan size, albeit, check the strings attached).

And here’s one more tip. When locking in or comparing rates from a new lender, consider 3-year or 4-year fixed rates if the rate is materially better and you can handle some rate risk. (Note: Some lenders only allow you to convert into a 5-year term.) If you gain a 1/4-point discount in a slightly shorter term it can save you more if rates don't climb as much as expected.

A three- or four-year fixed term also lets you renegotiate sooner, a key point given the average five-year mortgage lasts only 3.8 years. This helps if:

a) you need to move and/or borrow more

b) you can time it with your maturity date, and

c) you want the best rates with no penalty.

Also important is the fact that rates move in cycles. With borrowing costs suppressed by stable long-term inflation, it’s become arguably less likely that prime rate will shoot up and stay there for more than two to three years.

And if prime does climb above its 10-year average, that's when (as the chart below suggests) switching to a variable rate has the best probability of success.