Fixed Rates Move Up and Variable Rates Look Better By Comparison

Five-year fixed-mortgage rates moved higher last week as lenders continued to respond to the recent run up in Government of Canada (GoC) bond yields, which have risen from a low of 1.13% on May 1, 2013 to a high of 1.63% on June 12, 2013.

Fixed-mortgage rates have been at ultra-low levels for a long time, so it’s not surprising that the vast majority of borrowers have been opting for the comfort and familiarity of the ‘banker’s favourite’ five-year fixed term (here is a post I wrote that explains why I call it that). But after the recent increases to five-year fixed rates, I think there is an increasingly compelling case to be made for the variable rate instead.

Here are five reasons why I think the five-year variable rate is worth a fresh look:

1. For much of the past year, the spread between five-year fixed and variable rates was less than 0.25%, which meant that it would take only one increase by the Bank of Canada (BoC) to make five-year variable-rate mortgages more expensive than their fixed-rate alternatives. After the latest round of fixed-rate increases, this spread is now greater than 0.50%, which gives variable-rate borrowers a wider ‘margin of safety’ between variable and fixed rates.
2. If you’ve recently agreed to purchase a home or have a renewal coming up, you need a mortgage at a specific future date. If the vagaries of bond-market investors happen to push up five-year GoC bond yields at the same time that you need a mortgage, opting for a five-year fixed rate locks in that short-term yield spike for the next five years. Conversely, variable rates don’t move until the BoC raises its overnight rate and this happens much less frequently, and on a more measured and considered basis.
3. When borrowers dismiss the variable-rate option, the most common justification I hear is that they’re worried they won’t be able to afford future rate increases. Most of these same borrowers are surprised to learn that they can only qualify for a variable-rate mortgage if they prove that they can afford a doubling of rates over the next five years. That’s because lenders now qualify variable-rate applicants using the BoC’s Mortgage Qualifying Rate (MQR) which currently sits at 5.14% (here is a post I wrote that explains the MQR in detail). If you can pass the MQR’s stringent test, then you should feel confident that you can afford substantial, and even unlikely, future rate increases. Variable-rate mortgages also come with the option to convert to an equivalent fixed rate term at any time with no penalty. While the conversion rates offered by different lenders can vary widely, this free lock-in option gives you the ability to eliminate further variable-rate risk.
4. Variable-rate mortgage prepayment penalties are limited to a maximum of three-months’ interest by any lender who is regulated under the Bank Act (which basically includes every lender except for credit unions and private lenders). Fixed-rate IRD penalties, in contrast, can be staggeringly high (see my post on the subject). If you think there is any chance that you will have to pay out your mortgage before the end of its term, consider that a variable-rate mortgage penalty could easily be thousands of dollars cheaper than a fixed-rate mortgage penalty.
5. Most economists are not forecasting an increase in the BoC’s overnight rate until the second half of 2014. The gap between now and then may not sound like much if you’re deciding how to structure your mortgage financing for the next five years, but consider that those same economists had been warning of imminent BoC rate increases up until the start of this year. In fact, most of our prominent economists seem to err on the side of being early, rather than late, on their forecasts for BoC rate increases. So if they’re now predicting that the next overnight rate hike won’t be until late 2014, then chances are good that it’ll be long after. In the meantime, the gap between now and whenever that moment arrives gives you time to bank the interest-cost savings. (Reminder: the best way to do that is to set your payments at the same level they would have been at if you had chosen a five-year fixed-rate mortgage – you’ll pay off your mortgage more quickly and get comfortable with a higher payment amount while you do it.)

Five-year GoC bond yields were down four basis points for the week, closing at 1.53% on Friday. All lenders have now raised their five-year fixed rates in response to the recent run up in bond yields and market five-year rates are now offered in the 2.99% to 3.09% range.

Five-year variable rate discounts are offered in the prime minus .50% to prime minus .45% range (which works out to 2.50% to 2.55% using today’s prime rate). Importantly , these more deeply discounted variable rates can be found at lenders who also offer excellent terms and conditions, as long as you know where to look.

The Bottom Line: When market conditions change, it’s important to take a step back and re-examine the broader picture. Now that fixed-mortgage rates have increased, the case for a variable-rate alternative has grown more compelling and I think that borrowers who can qualify for this option are well advised to give it serious consideration.