Unless you’ve been able to avoid the news (or the gas pumps!) for the last year, you likely weren’t surprised when the Bank of Canada began raising interest rates in March. But the speed and size of those hikes – in response to surging inflation – caught many people off-guard.
At the start of the pandemic, the Bank of Canada slashed its benchmark rate (which sets the pace for rates charged on variable-rate mortgages) from 1.75% to 0.25%. As inflation ticked higher through 2021 and it became clear that rising prices weren’t transitory. Central banks needed to respond with higher interest rates, and quickly.
And quickly the hikes have come. Since the Bank of Canada started this rate-hike cycle in early March, it has raised rates from 0.25% to 1.5%. The yield on 5-year government bonds has nearly doubled, from 1.6% to around 3%. That has led to a similar increase in five-year fixed mortgage rates, which are tied to these bond yields.
So if you hold a mortgage, either fixed or variable, what should you do? Here are some strategies for riding out this rising-rate period while keeping your monthly cash flow intact.
Variable-rate mortgages: consider your risk tolerance when deciding to lock in
Let’s start with variable-rate mortgages, because their rates rise in lockstep with the Bank of Canada’s rate hikes.
Variable-rate-mortgage holders can take some comfort in the fact that, over long stretches, these mortgages tend to cost less than their fixed-rate cousins. For example, over a 25-year timeframe from 1996 to 2022, rates on variable mortgages averaged 4.14%, versus 5.30% for fixed rates, according to some studies.
But there have been periods when fixed rates have outperformed variable, and of course, variable rates can fluctuate widely during the amortization of the average mortgage. A look back just a few months, to March 2022, confirms this.
Prior to then, variable-rate-mortgage holders were likely paying an interest rate in the neighbourhood of 1.5%. Today, after two 50-basis-point increases and one 25-basis-point move from the Bank of Canada, that rate would be somewhere near 2.75%.
That’s still historically low, but these hikes add up. With a $700,000 mortgage (not uncommon in BC today), for example, and 24 years of remaining amortization, payments would be around $420 more per month today than in February.
This is why it’s important that only people with strong cash flow consider a variable, so they can ride out periods of higher rates until they give way to falling rates (and rate cuts are possible if we see an economic downturn in 2023, as some economists expect).
The takeaway? If you have a variable-rate mortgage and find yourself worrying before every Bank of Canada announcement, you may wish to speak to your advisor about converting to a fixed rate. Your payments will go up, as most fixed mortgage rates are now above 4%, but the price may be worth it if the stable payments bring you peace of mind. Otherwise, it could pay to wait until the gap between fixed and variable rates narrows before locking in.
Most variable-rate payments stay steady – but it still pays to act
Most of today’s variable-rate mortgage holders do have some payment stability built in, as their mortgages tend to devote more of their monthly payment to interest and less to principal as rates rise, keeping their overall outlay the same.
This, however, means the payment could jump at renewal time, in order to keep the borrower to your amortization schedule. And borrowers who hit their mortgage’s “trigger rate” – or the point at which they’re no longer fully covering their interest obligations – may get a call from their lender to arrange for an immediate payment increase to keep up.
Using your mortgage’s payment-increase option is a good way to stay ahead of rising rates, but if you have extra cash, it may be better to make a lump-sum payment instead (most variable-rate mortgages allow increases to monthly payments or lump-sum payments without penalty up to certain limits).
That’s because, with a lump-sum payment, the total amount is deducted straight from your principal at the time you make the payment. But with a payment increase, the amount you’re shaving off of your principal is harder to quantify, as rates will change throughout the life of a mortgage.
Finally, what if you reach the end of your mortgage term (five years in most cases) and are behind on your amortization? Depending on your situation and your financial institution, there may be options available to bring your payments to a more manageable level, however, keep in mind these options always mean extending your amortization and increasing your overall interest costs.
Fixed rates: How to minimize payment increases at renewal time
With fixed rates, of course, borrowers know what their payments will be month in and month out throughout the mortgage’s term, which helps with monthly cash flow, especially in periods of high inflation like the one we’re facing today.
But rising rates are still worth watching, even if you’re still early in your mortgage’s term.
For example, buyers who took out a mortgage a year or more ago, when rates were around 2%, are almost certain to be paying more come renewal time. How much more is an open question, of course, but given that most of today’s fixed mortgages rates are more than double what was offered at the height of the pandemic, an increase is likely.
That means it’s possible that these borrowers would face a mortgage rate that’s doubled come renewal time. If this isn’t sustainable, some options may be available, such as the ability to extend your amortization, but that would be at the discretion of the lender and would likely only be possible if you have built up a minimum of 20% equity in your home.
For a borrower concerned they may end up in this situation, the best approach could be to increase monthly payments, make one-time payments or both in order to bring the principal down as much as possible before the term ends. It would also be advantageous to do so soon, while rates are low, rather than saving the money until the rate is higher.
A note on extra mortgage payments
There is one other caveat when it comes to mortgage prepayments: you’ll want to take a holistic view of your financial picture to ensure you won’t need any money you put on your mortgage now for other purposes later.
In other words, let’s say you have an unexpected home repair that costs $5,000, but you’ve already put these funds on your mortgage, which is currently at a 2.75% rate. If you then have to put $5,000 on a credit card with a 17% interest rate, you’ve lost the benefit of the early mortgage payment.
An advisor can help you choose the right mortgage plan for you
While the first half of the year has been notable for ever increasing interest rates (with that trend expected to continue), you may be thinking about what that means for your home ownership dreams. Life and your dreams don’t necessarily have to be put on hold. There are solutions and strategies at hand that can help you achieve your goals; this is where an advisor can help.
Now more than ever, it’s important to have an updated financial plan – something your advisor can help you with. Once you’ve got a snapshot of your income, expenses and net worth, you can clearly see what you can make available for extra or increased mortgage payments, and increasing your peace of mind. Make an appointment today.
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