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Robert McLister: Even though all signs point to falling interest rates, why are borrowers still afraid of variable rate mortgages?
Published August 23, 2024 • Last updated 1 day ago • 5 minutes reading time
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A house for sale in Toronto's West End. Photo by Graeme Roy/The Canadian Press Files
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For a seemingly endless 27 months, from March 2022 to June 2024, adjustable-rate mortgage holders watched in fear as Canada's benchmark interest rate rose sharply and then remained at its peak.
Now we have reached the back of the hill, with two rate cuts under our belt and another one due on September 4th.
However, the clearest sign of Global interest rates have peaked will come from Jackson Hole, Wyoming, on Friday. The most powerful banker in the world, Federal Reserve Chairman Jerome Powell, will speak. He is expected to announce a 25 basis point interest rate cut on September 18.
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This came after Fed minutes released on Wednesday showed that the “overwhelming majority” of committee members supported a rate cut in September, barring any inflationary economic data surprises. A Fed easing cycle would also be accompanied by further rate cuts by the Canadian central bank.
Despite the favorable opportunities, most borrowers do not dare to take out a variable mortgage. Either they lack the courage or, as we will see below, the option.
Recent data from StatsCan shows an overwhelming preference for the security of five-year fixed rates – more than ten times as many borrowers opt for a five-year fixed rate (or longer) over a variable rate. But why?
Given the wealth of information available, anyone who Googles interest rate history and academic research can see that five-year fixed rates rarely come out on top when we are at the peak of an interest rate cycle.
Yet most people avoid variable interest rates like they're a blind date set up for them by their ex. Here's why:
#1. Fear
People know that interest rates have peaked because the Bank of Canada has already cut them twice. But they don't know how long this peak will last.
In the past it rarely happened:
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(A) The Bank of Canada begins a rate-cutting cycle after rates exceed their 10-year average, only to see…
(B) Tariffs will boomerang within a few years.
This happened in the disco era of the late 1970s/early 1980s, but in terms of inflation, monetary policy (direct inflation targeting did not exist then), debt burdens, energy independence, technology, financial markets, demographics, etc., it was a different era.
Yet the financial colonoscopy that variable rate borrowers have been subjected to in the recent rate hike cycle is still all too evident. For many, variables seem too precarious, despite their historical dominance when Bank of Canada interest rates are so restrictive.
#2. Difficulties in qualifying
The government's “stress test” makes it more difficult to qualify for a variable rate mortgage than a fixed rate mortgage.
For example, if you go to a bank and ask for a five-year fixed-rate mortgage, you will have to prove that you can afford an interest rate of around 6.90 percent or less. That's 200 basis points above the actual interest rate.
However, if you apply for a variable mortgage, you will need to prove that you can afford an interest rate of around 7.90 percent.
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This additional percentage point in the qualifying interest rate means that, all other things being equal, you will need to demonstrate significantly more income to be approved for a variable mortgage.
In fact, government policy forces people with higher than average debt service ratios into fixed mortgage terms that may not be in their best interest. Welcome to the idiosyncrasies of the Canadian mortgage market.
#3. Constant payments
For most adjustable-rate mortgages, payments do not change when the prime rate falls. For example, “With CIBC's adjustable-rate mortgages, monthly payments are fixed, so the repayment period either increases or decreases as interest rates rise or fall,” explains Josh Burleton, senior consultant of public affairs at CIBC.
In a case where a borrower has a variable interest rate of 0.75 percent of the prime rate with 20 years left to run, Burleton says, and the interest rate is cut by 25 basis points, “the interest rate would decrease by $20 per monthly payment due to the unchanged payment.” That's for $100,000 of mortgage balance.
While a rate cut is all well and good, given the high cost of living in Canada, many people are hoping for a rate cut. You won't find that at four of Canada's five largest banks. Still, some bank customers don't want to switch lenders, and others may not know they can get a variable rate elsewhere that falls with the prime rate, so they simply opt for a fixed rate.
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Mortgage Tip: Scotiabank is the only one of the five major lenders that offers decreasing rates with each drop in the prime rate. And there are many other banks, mortgage lenders and credit unions with this feature. Mortgage brokers know who they are.
A well-founded bet
The futures markets, where traders bet on future interest rates and hedge against interest rate risk, suggest that we can expect significantly lower interest rates by the end of the Bank of Canada's rate-cutting cycle.
Data from CanDeal DNA shows that markets are betting on a 200 basis point drop in the Canadian overnight rate. This means a drop in the Canadian base rate from 6.70 percent today to 4.70 percent by 2026.
If variable rate borrowers hit the jackpot, there is little mathematical doubt that they would save more with a flexible mortgage.
The problem is that betting on the market is like trust trusting a compass in a magnet shop. It is often wrong, and there are risks in this interest rate cycle that we have not seen before: a disregard for balanced federal budgets, inflationary deficit spending, the risk of renewed inflation in the housing market, persistently high inflation in the services sector, deglobalisation, etc.
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And with some economists predicting we will emerge from this easing cycle without a recession, it's possible that interest rates won't fall as much as the market expects.
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Regardless, most well-qualified, risk-tolerant borrowers should try their luck with a variable rate. Even with a drop of just 100 basis points from 200, variable rates won't break the bank compared to fixed rates. Additionally, a variable rate will give you a cheaper prepayment penalty if you want to terminate the mortgage early and/or refinance. Plus, you can switch to a fixed rate at any time with no penalty fees.
Robert McLister is a mortgage strategist, rates analyst, and editor of MortgageLogic.news. You can follow him on X at @RobMcLister.
Want to know more about the mortgage market? Read Robert McLister's new weekly column in the Financial Post and find out the latest trends and details on financing opportunities you can't miss.
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Mortgage interest rates
The rates shown below are updated by the end of each day and are taken from the Canadian Mortgage Rate Survey by MortgageLogic.news. Postmedia and Imaginative. Online Inc., the parent company of MortgageLogic.news, receive compensation from certain mortgage providers when you click on their links in the charts.
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