Should variable mortgage holders switch to fixed as more Bank of Canada rate hikes loom?

Ahead of the next Bank of Canada interest rate announcement on April 13, economists predict rate increases could be more aggressive and happen sooner.

Last month, in a much-anticipated release, the Bank increased its benchmark interest rate by 25 basis points (bps) in a move toward achieving the 2% inflation target. A quarter percentage point increase or decrease aligns with the Bank’s actions historically.

Forecasters, however, speculate that a half-percentage-point increase could be on the table, and the Bank has implied rates need to rise further.

“We have taken action and will continue to do so to return inflation to target, and we are prepared to act forcefully,” Sharon Kozicki, the Bank of Canada deputy governor, said in a speech last month.

While an increase will directly impact new homebuyers, reducing the amount they can borrow, many existing homeowners with variable-rate mortgages will see a gradual impact. The Bank suggests that nearly three-quarters of mortgage holders in Canada have fixed rates, with only about 20% of loans up for renewal annually. The portion of homeowners with variable mortgages will see the immediate effects of a rate increase on their payments.

How interest rate changes affect your variable mortgage

“Variable rates still offer an opportunity for borrowers to take advantage of lower rates, lower payments, and potentially a lower qualifying rate, which could increase the amount they can borrow,” says Sung Lee, RATESDOTCA expert and mortgage agent. “ This option, however, does come with near-term risks as we expect to see several rate hikes over the next couple of years.”

Say you have a variable-rate mortgage, where your monthly payments fluctuate according to the prime rate. If the prime rate goes up, your bi-weekly or monthly payments will increase. If rates were to fall, you’d pay less. With rates rebounding from record lows, the former seems more plausible in the near term.

“A way to take advantage of the potential savings of a variable rate without impacting future budgets or cash flow is to choose a variable rate mortgage with fixed payments,” says Lee. This would have to be done when you sign up for your mortgage, though.

In this case, a rate increase would mean that a bigger portion of your mortgage payment would go toward the interest on the loan and less toward the principal — but the payment amount would stay the same.

Typically, variable mortgage holders access lower interest rates than their fixed-rate counterparts for taking on more risk. There is, however, a safety net of sorts for those who want to change their mind at some point throughout their existing variable mortgage term. A variable mortgage holder can “lock in” a fixed rate once, at any time, for the remainder of their term. A person might decide to convert their variable mortgage to a fixed rate for financial security, for example.

With the impending Bank of Canada announcement, variable mortgage holders may be weighing their options. Is now the time to make the switch?

Should variable mortgage holders convert to a fixed mortgage?

Currently, the spread between variable and fixed rates is about 125 bps. That means homeowners can save money by going with a variable rate today. They must weigh the risks, however.

In her speech, Kozicki explained how the rapid growth in house prices led more households to take on large mortgages relative to their incomes — a growing share with variable rates.

Rising interest rates could make homeowners with variable mortgages and high loan-to-income ratios feel squeezed. For the already financially stretched, it could spell trouble depending on how high rates go.

“A fixed rate is great for someone willing to take on a higher rate with the security of knowing it won’t change during the term,” says Lee. “In a rising interest rate environment, locking in a rate today eliminates the risk of uncertainty and helps to keep your budget in check.”

More to consider with mortgages than just the interest rate

While locking in a good interest rate is helpful, the ability to service your debt is imperative. The number one question to ask yourself is: Can I make my payments? Next, consider your long-term goals.

“At the end of the day, choosing fixed versus variable is always a personal decision based on risk tolerance, budget, and future plans,” says Lee.

Most first-time homebuyers choose fixed-rate mortgages for security, despite paying slightly higher interest rates for that certainty. Often, seasoned homeowners with a stable income can afford the fluctuating payments of a variable mortgage, reaping the benefits of lower rates. But it’s all circumstantial.

For instance, if you convert your mortgage to a fixed rate but intend to sell your home or refinance before the end of your term, you’ll likely pay higher mortgage penalties for breaking your mortgage early. Generally, fixed-rate mortgage holders must pay the greater of three months’ interest or the interest rate differential to break their mortgage, which can equal tens of thousands of dollars. Variable-rate mortgage break penalties are usually equal to three months’ interest on your loan.

While you can’t plan for every outcome, you should contemplate your future from a financial standpoint. A variable mortgage might be a good fit if you can tolerate the risk; however, a fixed-rate mortgage can offer stability and peace of mind through uncertain times. Speak with your mortgage lender or broker if you have concerns about the looming rate hikes. Don’t make impulsive decisions out of fear of what might happen — it could be costly.