Variable-rate mortgages were never God’s gift to borrowers, even if that’s how it seemed a few years ago when interest rates were at generational lows.
And just the same way, they’re not as treacherous as they’re widely considered to be right now.
The rate cut Wednesday by the Bank of Canada makes it official: The rehabilitation of variable-rate mortgages has begun. Don’t dismiss them out of hand if you’re buying or renewing.
The term variable-rate mortgage is a category covering two types of mortgages with rates that reflect up and down moves in the prime rate used by banks and other lenders. The prime tracks changes in the Bank of Canada’s overnight rate.
The latest drop in the overnight rate will decrease the prime and rates on both types of variable-rate mortgages by one-quarter of a percentage point. But the impact will be felt differently.
Adjustable-rate mortgages modify your payments to reflect changes in rates, which means you now pay less than you did before the latest Bank of Canada rate cut. A true variable-rate mortgage keeps your payments the same – just the rate is variable. Several banks offer true variable-rate mortgages, while a few banks and the lenders available through mortgage brokers offer adjustable-rate mortgages.
Variable-rate mortgages as a broad category built a long-time loyal fanbase among borrowers who noticed that rates mostly went down in the past few decades. Then, in March, 2022, the Bank of Canada began an aggressive series of rate hikes to cool inflation. Rising rates have either added hundreds of dollars a month to people with adjustable-rate mortgages or increased the amortization for those with true variable-rate mortgages.
These outcomes explain why the mortgage industry seems more careful than it used to be with variable-rate products.
“I think we have to accept the fact that maybe there was a segment of our group that did not properly educate our clients at the time, didn’t look into long-term suitability,” said Matthew Shantz, a mortgage broker with Dominion Lending Centres FC Funding. “And so, I think there is a level of extra caution that’s taking place right now.”
Today, Mr. Shantz sees an argument for going with a variable-rate mortgage, provided a borrower has a predictable, ideally growing income. Someone who carries a mortgage into retirement is not in this category.
One reason to consider variable-rate mortgages today is the hefty discounting available. As of recently, Mr. Shantz has been able to get a discount of a full percentage point off the prime rate for borrowers who put down less than 20 per cent and thus have to pay for mortgage default insurance. Non-insured mortgages – those with down payments of 20 per cent or more – get 0.5 to 0.6 off prime.
The real appeal of variable-rate mortgages is found in the economic outlook. The Bank of Canada has now made two quarter-point cuts in its overnight rate, and more is expected as inflation eases.
At the beginning of the week, before the drop in the overnight rate, an insured five-year fixed rate at a mortgage broker would have been 4.79 per cent and an uninsured rate might have come in just above 5 per cent. Insured variable-rate mortgages went for 5.95 per cent – that’s prime minus 1 percentage point – and uninsured went for roughly 6.45 per cent.
After the latest Bank of Canada announcement, expect it to take four or five more quarter-point rate cuts to make variable-rate mortgages cheaper than five-year fixed mortgages are right now. Is that feasible?
If the last few years have taught us anything about economic forecasting, it’s to prepare for disruptions and detours before we get to where we expect to be. Theoretically, rates could start backing up if inflation reasserts itself.
With that boilerplate out of the way, it seems reasonable to expect rates to keep falling this year and next. In its July, 2024 forecast, RBC Economic has the overnight rate 1.5 points lower in the third quarter of next year than it stood after the cut on Wednesday.
The two popular choices with people currently starting or renewing a mortgage are three-year fixed and variable rates, mortgage agent Tuli Parubets said. But lately, she’s noticed some banks competing hard on five-year fixed rates.
The idea is to get people to lock in at today’s relatively high rates for five years. “It’s a bit of trickery,” she said. “Like raising prices before a Boxing Day sale.”
Within the broad variable-rate world, Mr. Shantz likes the adjustable-rate option right now because it offers potential for borrowers to either reduce mortgage payments and increase household cashflow, or keep payments level and pay down additional principal.
Two additional points to consider about the variable rate option: You have the option of locking into a fixed-rate mortgage when mortgage rates bottom out, and you pay just a three-month interest penalty if you break your mortgage. Expect the penalty for fixed-rate mortgages to be larger.
The more modest breakage penalty is not trivial. Mr. Shantz said he’s seen about 50 per cent of five-year fixed mortgage clients getting out before the maturity date.
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