The Spread Between Fixed and Variable Nears a Decade-High

The divide between average fixed rates and average floating rates is approaching the largest it's been since August 2011. That was the last time the "spread" between the two was over one percentage point.

Here are the numbers:

• Nationally available discounted 5-year fixed rates currently average around 2.07%, as calculated by RATESDOTCA.
• Similar variable mortgage rates are averaging 1.14%
• That results in a spread of 93 basis points.
  
  (Note: These rates are a simple average of default-insured rates, which apply to mortgages with less than a 20% down payment, and uninsured rates.)

Source: RATESDOTCA
 

Since 2009, the spread between fixed and variable rates has fluctuated between -.28 to 2.08 percentage points. Today, we’re not far off the midpoint of that range (i.e., “normal”).

In 2019, the spread between fixed and variable rates evaporated completely. Five-year fixed rates actually became cheaper than floating rates. This coincided with what economists call an inverted yield curve. At the inverted yield curve's extreme in September 2019, for example, 5-year fixed rates were lower than comparable variable rates by an average of 0.18 percentage points.

That, of course, made fixed-rate mortgages seemingly a "no brainer" for much of the year. Borrowers figured that five full years of “rate security” for less than a variable rate was practically a free lunch. A year later, rates were down another 0.75 to over 1.00 percentage points, thanks to a once in a lifetime (hopefully) global pandemic.

What borrowers think now

With the fixed-variable spread now back in “normal” territory, will homebuyers alter their decision-making?

Our guess: The percentage of borrowers opting for a variable rate will likely remain in the 16-29% range for now, for various reasons:

1. Fixed rates are still at historic lows. Despite bouncing more than half a percentage point from their all-time bottom in December, today’s fixed rates still offer historically tremendous value. Case in point, default-insured 5-year fixed rates can be found as low as 1.99% or less, while uninsured rates are available for 2.14% or less. And that’s for a fair-penalty lender, where you won’t get taken advantage of if you have to break the mortgage early.

2. Risk aversion. Canadian borrowers are well known for not taking chances with their mortgages. Floating rates create uncertainty, and the price of mitigating uncertainty is the fixed-variable spread, something the majority of Canadians are willing to pay.

3. Rate-hike expectations. If Canada’s economic recovery plays out as expected, mortgage rates should start climbing again by mid-2022. By how much? Anywhere from 1.50 to 2 percentage points over the next five years, according to current market forecasts published by Bloomberg. Knowing this, most borrowers prefer to insulate themselves from what’s widely seen as a near certainty: an economic recovery with rising rates. (Mind you, certainty and the interest rates should rarely be used in the same sentence.)

The fixed-variable spread will ultimately exceed 1.00 to 1.25 percentage points. That’s when we may see a noticeable shift in variable-rate adoption. With the bond market projecting five rate hikes within 36 months, it may take a big round number (like a 1-percentage-point rate advantage) to convince more than a quarter of Canadians that floating rates are worth the risk.