With an impending Bank of Canada rate increase occurring on October 26, 2022 many are wondering if they should be locking in a mortgage rate or making a change to their mortgage.
With the variable rate, the inevitability of higher rates was always part of the plan, but clearly, it was not forecasted that rates would need to reach such high levels.
So the questions now are, what will higher rates look like and how should we best prepare?
- As of October 15, 2022 we will likely see variable rates increase by another 1%.
- If inflation is still a major concern after this substantial increase, we could see even higher rates until inflation is settled.
- However, we can see compelling forecasts in the financial markets that Bank of Canada rates should fall again in 1-2 years. In other words, it looks like the Bank of Canada will be increasing rates more substantially to slow inflation, and then once inflation is under control, rates will likely drop. More of a ‘sharp rate peak’ than a gradual transition of rates.
- We are not expecting rates to fall to emergency levels as seen during covid-19, but more of a normal rate likely to be in the 3% range.
The pocket book effect of higher rates:
One of the best tools we can apply to most situations is an understanding of the basic math of a 0.25% increase on $100,000 of mortgage balance.
If we multiply 0.25% * $100,000, that’s $250 of interest. If we then divide $250 of interest by 12 months, this works out to just under $21 per month. That’s $21 of higher payment, per 0.25% of mortgage rate increase, on every $100,000.
So, how does this apply to your situation?
For example, if you have $550,000 of mortgage, we would first multiply $21 per month times 5. This is because we have a $21 payment increase per every $100,000.
So in this case of $500,000, it would be a $105 payment increase.
But more specifically, the mortgage amount in this example is $550,000 – we need to account for the extra $50,000. Since $50,000 is ½ of $100,000 then we can apply ½ of the $21 increase or roughly $10 of additional payment, per $50,000.
So we have a $105 payment increase on the base $500,000 ($100,000 * $21 * 5 = $105) and an extra $50,000 which is an additional $10 per month.
So the total payment increase in this example would be approximately $115 per month of interest.
If it’s easier, just round up or down to the nearest $100,000 of mortgage. For example, if you have $550,000 in mortgage you could pretend and say it’s $600,000. Then the math is easier at $21 per $100,000 times 6 or $126 per month in extra payment.
We are expecting rates to increase by another 1%. So the same idea can be applied to every $100,000 at 1%. That’s $1000 per year of payment increase per $100,000 or, dividing $1000 by 12 months, approximately $85 per month per $100,000 of mortgage.
If you are looking for a more specific calculation, feel free to connect with us.
Adjustable Rate Vs. Variable Rate Difference
If you have an adjustable rate mortgage, your rate and payment will have been increasing since March (unless you got into the variable rate after March 2022). This type of variable rate mortgage ensures that your mortgage will be paid out over the original Amortization that was initially set out.
The classic variable rate mortgage does not increase in payment until the trigger rate is reached. In this case, once the interest payment becomes greater than the payment that your mortgage was originally approved at, the payment starts to increase and would only be an interest payment. In this case the amortization can stretch out substantially, and it is recommended that additional pre-payments are made to help lower the amortization.
Either way, the cost of the mortgage moves higher with each interest rate increase, as indicated in the math just above.
Should I lock in a Fixed Rate now?
When considering a rate lock in, it’s important to keep in mind that current fixed rates are close to 5% in most cases. Over the past year, the fixed rates have already risen to price in the anticipated increase by the Bank of Canada/ Variable rates. Fixed rates are not priced directly by the Central Bank, they are priced based on Government of Canada Bond yields.
If your current variable rate is prime minus 1%, then you are currently at 4.45%. This means that a 1% Central Bank increase would put you at 5.45%.
These high rates are most certainly indicative of a significant economic slowdown, designed to combat inflation.
However, this is clearly not a gradual incline in rates. It is more of a ‘shock and awe’ strategy to tame inflation quickly, and then reduce rates once inflation is under control. Lower consumer demand will slow inflation. In other words, the length of time the rates will be at their high point is projected to be shorter, forming more of a ‘mountain peak’ than a plateau where the peak rates endure for extended periods.
It will take a few months, into 2023 for rates to reach their peak, but are projected to come down again in the shorter term.
A key question is, do you want to lock in 1% worth of rate increases now, with a fixed rate? Or wait for the rate to come up on its own with the variable rate?
What if you locked into a 4.99% fixed rate now, only to see rates drop again in 2024? Are you comfortable with the risk of a rate drop, while being locked into a higher 5 year fixed rate?
If you’re worried that the rate could increase higher than 1% then it can be worth locking into a fixed rate, mainly for peace of mind.
One excellent strategy is to make extra pre-payments in anticipation of higher rates, to take advantage of the current lower rate and get ahead on mortgage principal. Then as rates increase, you can reduce the increased payment later in the year
Locking in Your Rate: The Suggested Process
If you’re leaning towards locking in your variable rate to a fixed rate, a shorter-term fixed rate is suggested. Many banks may only allow for a 5 year fixed rate lock in and borrowers should see the risk that rates may fall in 1-2 years. Accordingly, to break the variable into a shorter-term fixed mortgage, a 3 month interest rate penalty will likely apply. This penalty needs to be factored into your decision-making.
The steps below will help to get started, to see what may work best for you.
- Contact your current lender and see what their best rate lock in will be. Will they offer you a 2 year or 3 year fixed term?
- Let your lender know that you are shopping and to provide you with their best offer accordingly to retain your business.
- Ask the current lender what today’s breakage penalty will be.
- Connect with us at Altrua, and see how low we can get your rate.
- Connect with us at Altrua to do a cost-benefit analysis to see if it makes sense to break.
We have found that over dozens of such cost-benefit calculations, the penalty will not justify itself over 2 years. However, over 3 years the 3 month interest penalty can more easily justify itself. Or if the variable rate has become unacceptable psychologically and you are losing too much sleep over the variable, then the emotional benefit may substantially outweigh what the cost-benefit numbers are showing.
Understanding Penalties When Locking In – Predictable vs Unpredictable Mortgage Penalties:
Locking into a fixed rate has another important outcome, with regards to penalty. Whereas variable rates offer a predictable 3 month interest penalty to break the mortgage, fixed rate mortgages have ‘Interest Rate Differential’ penalties which are often much, much higher than 3 month interest penalties.
Where this can really matter is, if there is a change to your mortgage or real estate situation during the mortgage term. If there’s a change, and it makes sense to break your mortgage, then you could be facing a much higher penalty than with a variable rate. As much as 3 – 5 times higher with fixed than variable.
Ask yourself, what are the chances that I might consider moving or refinancing to invest, consolidate debt, or spruce up the house in the next 5 years?
If you think the chance is 1% or more, then the penalty can really matter. It’s usually easier to plan our goals, going out a few months. However what you want, or what happens 2-3 years down the road is more difficult to predict, and so flexibility in the mortgage can be very important.
Or what if fixed rates are lower, closer to 2% in 2-3 years? In such cases, many borrowers want to break their fixed rate mortgage to get into a lower fixed rate mortgage, however they discover that the penalty is prohibitively high to do so. Right now fixed rates are higher but they could be potentially lower in a few years.
Locking in a mortgage rate – In summary:
If payment consistency, cash flow, and peace of mind is central to a lock in decision, then a rate lock in may be right for you. However, it’s important to consider all the variables involved including:
- The real effect of a higher rate on your monthly cash flow.
- The current pricing of fixed rates.
- The penalty to break your current variable and switch into a fixed rate with a different lender.
- Fixed versus variable rate breakage penalties and flexibility.
- Future changes to real estate and mortgage.
If when these points are considered, you are interested in locking in, ensuring you get the right fixed rate mortgage is very important. It’s not apples to apples when comparing mortgages in the market, and some fixed rate mortgages have major advantages over others – beyond rate.
Ultimately if your peace of mind is compromised, it may not be worth the potential savings of a variable rate and a fixed rate lock in can be a great move.
However, statistics have shown that those who hold the course on variable rates have saved more over time. Like buying into the stock market and sticking with it over the long term, through the ups and downs, a similar strategy holds true with variable rates. By holding the course, you are likely to reap the benefits of a variable rate.
