As rate cuts begin, many with renewing mortgages ponder variable vs. three-year fixed rates

For homeowners with mortgage renewals coming up in the next few months, the question is whether and how to take advantage of the beginning of interest rate cuts.

The Bank of Canada lowered its benchmark interest rate for the first time in four years on Wednesday and left the door open for more reductions to follow. But many economists believe the downward path of borrowing costs will be gradual, with the central bank possibly pausing for several months between cuts.

“Renewals have been a hot topic for a little while now,” said Victor Tran, a mortgage and real estate expert at financial products comparisons site Ratesdotca.

A slow-moving Bank of Canada poses a challenge for those with coming renewals. On the one hand, locking into a fixed mortgage rate for too long carries the risk of missing out on sizable cumulative savings from future rate declines. On the other hand, floating-rate mortgages are still considerably higher than some fixed-rate options and unlikely to drop quickly.

While the central bank’s trendsetting rate has a direct impact on floating mortgage rates, which usually rise and fall in tandem with it, it also affects the expectations of investors in the bond market, which influences the level of fixed mortgage rates that lenders offer to new clients. Many believe those rates will also move lower as the BoC proceeds with cuts.

Mr. Tran recalled the recent case of a client with a renewal coming up at the end of June whose dilemma encapsulates the quandary many borrowers are facing. The customer was undecided between locking into a competitive three-year fixed rate at 4.95 per cent, or opting for a variable-rate mortgage at 6.2 per cent.

Given the 1.25-percentage-point spread between the two rates and the expected gradual pace of rate cuts, Mr. Tran estimated it would take a year or longer for the variable rate to fall below the 4.95-per-cent rate of the three-year fixed.

The choice was between the immediately lower payment and security of the three-year fixed mortgage and the potential for greater savings of the variable rate, which also came with the uncertainty about the future trajectory of the Bank of Canada’s rate, Mr. Tran said. In the end, his client chose the fixed rate.

Unsurprisingly, borrowers are largely shunning five-year fixed-rate mortgages, which have long been the default choice for many mortgage shoppers.

“I haven’t done a five-year fixed in quite some time,” Mr. Tran said.

Frances Hinojosa, CEO and co-founder of Toronto mortgage brokerage Tribe Financial Group, agrees the three-year fixed continues to be an attractive and popular option. But borrowers should be aware that, in an environment of declining interest rates, it typically becomes more expensive to break a fixed-rate mortgage, she said.

“If rates go down and your rate is much higher, you’re very likely going to be looking at an interest-rate differential in the penalty, which could be tens of thousands of dollars,” she said.

Borrowers should also be aware of banks’ overtures about renewing mortgages early, Ms. Hinojosa said.

“I’ve had a few clients recently reach out to me because they got a renewal notice six months in advance.”

With rates expected to decline gently over the next several months, Ms. Hinojosa sees no reason to rush into a mortgage renewal. Instead, homeowners should take the time to explore their options, she said.

Obtaining a mortgage preapproval, through which a lender guarantees a given fixed rate for up to 120 days, still makes sense, she said. If rates move lower before your renewal rate, there is no obligation to stick with the rate that’s being held.

And anyone who signed on to a mortgage that required mortgage default insurance – mandatory for down payments of less than 20 per cent – should know that they don’t have to pass the federal stress test to qualify for a renewal with a different lender, Ms. Hinojosa said.

The test mandates that federally regulated lenders, in most cases, vet borrowers’ finances against rates that are higher than the contractual mortgage rate they are being offered.

Individuals with an uninsured mortgage must pass the stress test if they want to switch lenders at renewal. But someone renewing an insured mortgage will be able to qualify with a different bank based simply on the contractual rate they are offered at that bank, Ms. Hinojosa said. This holds even if the borrower has accumulated equity worth 20 per cent or more of the value of their house, she noted.

“You can actually qualify at another institution using the actual contract rate – the actual rate that you are getting,” Ms. Hinojosa said.