One of the biggest benefits of adjustable rate mortgages is that they give you options.
First of all, variable mortgage prepayment penalties are generally more affordable than their fixed-rate counterparts.
This is usually just three months’ interest and not the dreaded “interest difference” penalties that can come your way if you cancel a fixed-rate mortgage early.
In addition, you can commit to a fixed interest rate “free of charge” with almost all variable tariffs.
“Free” gets the scare quotes here because in practice this feature comes with a very real cost, and here’s why.
The timing of the rate lock is tricky
Rate locking features give borrowers a sense of control, but that control is often a mirage.
Let’s take today’s case for example. We are facing a looming war-related surge in inflation that even the Bank of Canada admits is imminent.
“Central banks always raise interest rates during an oil shock,” noted Stéfane Marion, chief economist at the National Bank of Canada, at the bank’s financial services conference on Wednesday. (He was referring to major oil shocks, of which there have been eight since 1956. History tends to repeat itself, doesn’t it?)
This pattern is one reason why derivatives markets are currently pricing in three interest rate hikes from the Bank of Canada over the next 12 months.
The problem is that fixed mortgage rates are tied to the yields on Government of Canada bonds. And these returns largely reflect where the market expects interest rates to go.
As the market expects higher interest rates, bond yields rise.
As bond yields rise, fixed mortgage rates follow them up the ladder.
Average five-year fixed interest rates have risen 25 to 30 basis points since the start of the war, according to the latest MortgageLogic.news interest rate survey.
However, there are still some offers available. For example, some offers for default insurance are still below four percent – probably not for long.
The problem is that lenders generally won’t offer you these rate deals if you already have a contract with them.
If they see that you want to commit – knowing you’ll have to pay a penalty if you leave – most will be happy to offer you a higher-than-market rate and hope you don’t shy away from it.
Instead of the 3.99 percent you just found for a new insured repair, the lender might offer something like 4.39 percent. Expect to pay at least 20 basis points more for an uninsured mortgage.
What is 40 basis points between friends?
Well, it costs about $5,600 over five years on top of an average Canadian mortgage, which is about $300,000.
That’s probably the minimum deviation most people face when binding a variable to a fixed variable, simply because they wait too long.
The psychology of the borrower can be detrimental
All of this could be worrying for any borrower on a tight budget taking out an adjustable rate mortgage.
So it’s no wonder that outside of the pandemic, Google Trends shows that searches related to getting a mortgage are now the highest in at least 17 years.
But many people tend to gamble. They expect to watch the market and see how the war develops and whether returns rise before committing.
This is a great plan if the timing works.
The problem is that bond markets price in price increases several weeks before your lender’s base rate changes.
Currently, traders believe the Bank of Canada is far more likely to raise interest rates by July 15 than even.
The five-year Canadian government bond yield began pricing in further tightening more than three weeks ago and has risen 53 basis points since the start of the war.
Now half a percentage point in credit costs is no joke. And if a borrower waits longer, they could find that the above 4.39 percent offer potentially increases to 4.59 percent or more.
All of this is why many borrowers who are unsure about committing to the loan experience one of two feelings:
1. Panic about missing the boat, which often results in them throwing in the towel and scoring half a point (or more) late.
or
2. The deer-in-headlights syndrome, which often leads to the decision to sit out the Bank of Canada rate hikes and “see what happens,” only to watch ruefully as the Bank of Canada hikes rates.
Both tendencies appear like clockwork in every interest rate hike cycle.
Of course, predicting interest rates is a wonderful way to discover that the interest rate market has a dark sense of humor.
Really, the only way to lock in at the “right time” is to be early and bet on getting inflation right.
Historically, mortgage lenders have had the greatest success in securing:
- After a major interest rate cutting cycle
- After interest rates have bottomed out for a while
- As inflation shows signs of warming up again
- The yield on two-year Canadian bonds is well above the Bank of Canada’s overnight interest rate.
When a supply shock like the current one occurs, it can boost inflation virtually overnight and improve the chances of rate lock-in even further.
Some rearview mirror analysis
What goes up usually goes down, and this also applies to interest rates.
“When oil shocks end, bond yields have historically fallen sharply,” Chen Zhao, chief global strategist at Alpine Macro, said in a recent report.
So if we suffer from interest rate problems for a few years, one should expect them to ease, given the resulting risk of recession.
Factors like these are why variable interest rates are best viewed as a roller coaster ride where the five-year average is more important than the stomach-churning ups and downs.
And sometimes that rollercoaster ride still results in a much higher interest rate on average than a boring old fixed-rate mortgage. In such cases, hindsight shows how paying for protection would have paid off.
If you had taken out your mortgage a few months before the last rate hike cycle – say January 2022 – you could have gotten a variable rate of 1.39 percent.
That was a whopping 150 basis points less than the then leading interest rate of 2.89 percent for five years.
Many of us still vividly remember the commentary back then insisting that the variable prepayment would cushion borrowers through the coming tightening cycle – especially after all the hand-waving from central bankers about “temporary” inflation.
Five years later, borrowers who paid that “insurance premium” of 1.50 percentage points for a five-year term – and met its terms – were significantly further ahead, almost $23,000 on a $300,000 mortgage.
In this sense, tariff insurance is a type of household contents insurance. You fret over every payment until your roof collapses, and then you’re a creditor.
Robert McLister is a mortgage strategist, interest rate analyst and editor of MortgageLogic.news. You can follow him on X at @RobMcLister.
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