Most lenders won't let you lock into a short-term rate, writes Robert McLister.Getty Images/iStockphoto
With the U.S. Federal Reserve projecting that interest rates are nearing a peak, it’s counterintuitive to think about locking in a variable mortgage. But as fixed rates start falling, some borrowers will want to do just that.
That’s probably a mistake.
For one thing, government bond yields heavily influence fixed mortgage rates, and yields usually drop before floating rates. As a result, you’ll see some alluring fixed-rate specials before variable rates decline.
McLister: This week’s lowest fixed and variable mortgage rates in Canada
But, by the time government bond yields start falling significantly, it’s likely that Bank of Canada rate cuts won’t be far behind.
Moreover, if the BoC cuts rates once, it almost always cuts multiple times.
The point is that you’ll likely pay more by locking in, even if you see what looks like an amazing shorter-term fixed rate in the weeks ahead.
If you’re dead set on converting from floating to a fixed, however, here are four things to think about:
Most lenders won’t let you lock into a short-term rate
Lenders want to tie you up for as long as possible. Most don’t want you taking a variable and then locking into a one-year fixed six months later, for example. Doing that can cost them money.
This is why the majority make you choose a fixed term equal to or greater than your remaining term when locking in your variable rate. Other lenders simply require you to choose a minimum term. Some require you to pick at least a three-year fixed or longer. Some limit conversions only to five-year fixed terms.
Lenders with limits like this prevent you from capitalizing on short-term rate specials, which we’ll see more of as bond yields fall.
Your payment may jump
Most people who got crazy-low variable rates with fixed payments have seen their amortizations extend. That’s because the share of payments going to principal drops as rates go up.
Let’s say you started with a 30-year amortization and one year later, rising rates push your effective variable-rate amortization up to 35 years. If you now go to convert to a fixed rate, the lender will likely shorten your amortization.
At most lenders, as well as the nation’s biggest mortgage lender, Royal Bank, that’s how it works.
“In the scenario provided, the amortization of the new fixed rate term would default to the scheduled remaining amortization (i.e. 29 years),” says Arjun Lombardi-Singh from RBC’s communications team.
At renewal, if your remaining amortization was longer than your original amortization, minus the time elapsed, the lender would do the same thing. In other words, bring you back to your originally contracted amortization.
The net result is, your payment often goes up in these scenarios, depending on rates at the time.
You may be stuck with your lender’s (subpar) offer
If your variable mortgage is closed, and most are, lenders have you over a barrel. They know you can’t leave without paying a penalty and it affects how competitive they are.
That penalty is usually only three months interest, but at today’s rates we’re talking roughly $1,500 per $100,000 of mortgage balance. Odds are, you won’t find a lower rate elsewhere to offset that cost, even if the fixed rate your lender offers – their “conversion rate” – is garbage.
One exception is if you have an open mortgage. Flexible lenders such as HSBC, for example, will let you out of a five-year variable rate after three years with no penalty.
Side note: I fear that this perk, one of the best features in Canada’s variable-rate market, may disappear if RBC takes over HSBC’s Canadian mortgage business later this year, as planned.
Penalties go up
Speaking of prepayment penalties, locking into a fixed rate typically means you’re exposed to a much more expensive penalty if you break the mortgage early.
In a falling rate market, which economists expect in the next year or two, fixed-rate penalties can easily be over three times bigger than a variable rate penalty – sometimes much more.
Now suppose you want to refinance that fixed rate later, or sell and rent before your term expires. If you don’t want to pay such penalties, you could be stuck with whatever replacement rate your lender wants to give you.
This is another reason why it helps to choose a transparent lender with deep-discount rates that are advertised online.
Rates are as of March 23, 2023, from providers that advertise rates online and lend in at least nine provinces. Insured rates apply to those buying with less than a 20 per cent down payment, or those switching a pre-existing insured mortgage to a new lender. Uninsured rates apply to refinances and purchases over $1-million and may include applicable lender rate premiums. For providers whose rates vary by province, their highest rate is shown.
Robert McLister is an interest rate analyst, mortgage strategist and editor of MortgageLogic.news. You can follow him on Twitter at @RobMcLister.
