Mortgages 101: What to know about fixed vs. variable rates in Canada

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Selecting a mortgage is one of the biggest – and most stressful – financial decision made by many Canadians. But a clear understanding of a few basic terms and concepts can help allay some the anxiety. Here’s a primer on the basics of mortgages, along with insights into the current market.

THE BASICS

What is a mortgage?

In plain terms, a mortgage is a loan most often used to buy a house, condo or some other type of property. It’s a set amount of money provided by a lender (often a bank, credit union or mortgage company), and is repaid over a set period of time (referred to as the amortization, often 25 years). The mortgage usually includes the purchase price minus the down payment, plus mortgage insurance if your down payment is less than 20 per cent or if required by a lender.

Payments include interest plus a portion of the principal and might also include property taxes, insurance or related charges. What’s left over after paying the interest and other fees then goes toward increasing your equity, or the portion of the property that you actually own. That also serves as collateral for the loan – meaning if you fail to make payments, the bank or other lender can take possession of the property.

What is a mortgage rate?

A mortgage rate is the rate of interest charged on a mortgage. While banks and other mortgage providers may advertise a particular percentage, the actual rate depends on the borrower’s credit history, among other factors. Mortgage rates are currently at historical lows, but are not likely to get any lower for the foreseeable future. There are two main types of mortgages rates – fixed and variable.

What are the types of mortgages: fixed vs. variable?

A variable mortgage rate fluctuates based on the so-called prime rate, a benchmark lenders usually adjust based on movements in the Bank of Canada’s trendsetting overnight rate. When rates rise, homeowners pay more in interest. However, not everyone will see their monthly payments increase when rates climb. Some variable-rate mortgages keep payments steady – up to a certain threshold – even as the interest rate moves up. Instead, these borrowers will see their amortization period extended in response to higher rates, meaning it will take longer to pay off the mortgage. You can also lock into a fixed interest rate at any time, without breaking the mortgage contract – and if you break the contract with a variable rate, the penalty is often much lower.

Mortgage renewals: Which is better, a fixed- or variable-rate?

A fixed interest rate mortgage typically locks in payments for a set term of two to five years. Fixed rates are often higher than variable, but offers peace of mind to homeowners their mortgage payments will be consistent for the years to come. It is not possible to switch from a fixed to variable rate without breaking the mortgage contract (which results in a penalty).

What is a mortgage ‘trigger rate’?

There is a little-known feature of many variable-rate mortgages known as the “trigger rate.” It’s the interest rate level at which lenders can adjust up a mortgage holder’s payment amount even if it would normally be the same every time.

If you have a variable mortgage rate with stable payments, the likelihood that you’ll hit your trigger rate depends on your mortgage balance and interest rate, Jamie David, director of mortgages and head of marketing at online rates comparison site Ratehub.ca, said via e-mail.

Mortgage holders can also usually find their trigger rate in their mortgage contract.

If you have a variable mortgage rate with fixed payments, you can estimate your own trigger rate with the calculator below.

How do I shop for a mortgage (and should I go with a bank vs. provider)?

The first step when considering a mortgage is evaluating your current financial situation and understanding your long-term financial goals. Determine not just what you’re able to pay but also if other features – like a flexible payment schedule – would be beneficial. Being a loyal customer at a bank doesn’t necessarily guarantee a good rate. Your best option is to comparison shop. Mortgage brokers can offer insights into rates from a variety of lenders. You’d also be wise to speak with a mortgage specialist at your bank, who can likely offer better rates than the other staff.

Is it better to use a bank or a broker?

The main difference is the bank mortgage only represents the products their institution offers, while a broker works with multiple lenders and is paid a referral fee. Brokers, who are regulated in Ontario by the Financial Services Regulatory Authority of Ontario, are often preferred by first-time buyers looking for the best rate.

It’s worth considering brokers who are recommended by a friend or a colleague who recently made a purchase – but also consider secondary references. You can screen brokers by e-ail: provide them an overview of your financial situation and evaluate their response.

What documents are necessary to get a mortgage?

In Canada, would-be homeowners will need access to many financial documents to get pre-approved for a mortgage and secure the loan. If you’re in the process of getting a loan, make sure you have:

• Two pieces of identification (passport, driver’s license, permanent resident card, etc);
• Proof of employment (including your salary or hourly pay rate; your position title and length of employment; if you’re self-employed, you will need your notice of assessment from the CRA for two years);
• Proof you can pay for the down payment and closing costs;
• Information about other assets and debts.

Have these documents ready ahead of time. To be especially thorough, include a cover letter, financial objectives and a short biography that runs one page at most.

What is Canada’s stress test?

Canada’s new stress test rules, which came into effect on June 1, 2021, means it’s now trickier to get approved for a mortgage. The new stress test applies to people with down payments on both sides of the 20 per cent threshold where mortgage default insurance is no longer required. You must now be able to handle the higher of a mortgage rate of 5.25 per cent or your contract mortgage rate plus two percentage points. The previous reference rate was 4.79 per cent.

What mortgage can you afford?

Getting a mortgage is one thing – being able to carry monthly payments without being “house rich but cash poor” is another. Big monthly expenses like daycare, car loans, emergency funds and saving for retirement or your children’s education don’t disappear when you’re a homeowner, so plan for those expenses while looking for a loan. Use Rob Carrick’s Real Life Ratio calculator to see how much in monthly payments you can comfortably afford.

What should you do before looking for a mortgage?

Before you go house-hunting, it’s important to understand your financial situation. Here are five things to understand before you look:

1. Find out your credit score: Bank of Nova Scotia, Canadian Imperial Bank of Commerce and Royal Bank of Canada, and the credit card issuer Capital One will let you check your score for free, as will online lender Borrowell and Credit Karma. Your credit score is not affected if you check it, and it will give you a good sense of where you stand financially.
2. Calculate your debt load: Use the debt service calculator offered by CMHC to see if your gross debt-service ratio is under 35 per cent (the rate required for people applying for mortgages insured by CMHC).
3. Understand the mortgage market: RateSpy.com’s mortgage rate news page will keep you on top of what’s happening with mortgages and the housing sector. If you want to understand how mortgage rates are set, read the Bank of Canada’s briefing note.
4. Compare rates: Use the mortgage dashboard on the Canadian Mortgage Trends website to see prime rates, the five-year Government of Canada bond yield, the benchmark qualifying rate and a typical rate for fixed five-year and variable-rate mortgages.
5. Consider mortgage penalties: A low rate is important, but watch out for penalties that lenders may charge for breaking your mortgage contract. Moving, refinancing at a lower rate, making additional payments toward your loan or paying off your mortgage early can all result in steep fees depending on your lender and the features of your mortgage. With a variable rate, terminating your contract early will usually result in a penalty equal to three months’ worth of interest on your remaining balance. With a fixed rate, penalties can be much higher and could reach tens of thousands of dollars. There are different formulas to calculate the penalty on fixed-rate mortgages, so make sure to ask your lender how they do it. Consider also how much you’re allowed to pre-pay toward the mortgage every year and whether you could transfer your mortgage to a new property without penalty.

Use the mortgage payment calculator on Ratehub.ca, where you can compare four different mortgage offerings.

PAYING OFF YOUR MORTGAGE

What are the pros and cons of paying off the mortgage ahead of schedule?

Paying off a mortgage earlier than expected will save money on interest and enables you to divert significant amounts of money to pay down debt or increase savings. But there can be downsides. People can become so fixated on paying off their mortgages that they end up paying for other expenses using lines of credit or credit cards. In addition, some banks will charge a “prepayment penalty” to those who end their mortgages ahead of schedule.

Is it better to pay off the mortgage or invest?

The first step should be to establish an emergency fund of three to six months of expenses. Having cash kept safely in a high interest savings account protects your financial and emotional health if you lose a job, have your income cut or run into unexpected big expenses.

Should you pay your mortgage down more or invest?

Once an emergency fund is established, consider your risk tolerance toward investing. Generally, it’s better to pay down the mortgage faster if the interest rate is greater than the expected return from investing. Paying down debt is a form of savings and means that, in the future, you will have extra cash flow that can be redirected to retirement savings or higher spending.

Should you pay off the mortgage or save for retirement?

If you pay down the mortgage, you get a guaranteed return and the emotional and financial benefits of being mortgage-free. But if you focus on RRSPs first, you may well be further ahead in the long run. For young adults who can’t afford to do both, it may be more tax-efficient to delay RRSP payments and pay off the mortgage early instead. Watch as Rob Carrick and Barbara Garbens offer further insights on this topic.

THE FUTURE

What’s in store for mortgage rates in 2023?

The Globe’s Robert McLister makes five confident predictions:

1. Variable mortgages will make a comeback: If the Bank of Canada begins to cut rates in 2023, floating rates should start to regain appeal as people aim to ride borrowing costs down
2. Home prices will bottom: According to Nanos, more Canadians expect home prices to fall than rise in 2023. As high interest rates weigh on affordability and unemployment, and mortgage defaults climb, the national average home price could take another leg down.
3. Demand for non-federally regulated lending will soar: A record percentage of mortgage applicants could be declined for mainstream mortgages in 2023. That’ll leave only private lenders, mortgage investment corporations and other non-federally regulated subprime lenders as options for many people.
4. More bifurcated mortgage competition: As mortgage default risk climbs in 2023, lenders will continue favouring liquid government-backed mortgage securitization. Online mortgage discounters will leverage such funding to continue their cutthroat competition, accelerating the race to the bottom on insured mortgage rates.
5. Regulatory credit tightening: Canada’s banking regulator plans to review federal mortgage underwriting guidelines in early 2023. That typically leads to new mortgage restrictions.

With reports from Erica Alini, Rob Carrick, Jessie Willms and Robert McLister.