When should you lock in your variable to a fixed rate mortgage?
If you are buying a home in 2022, which option will save you the most money?
If you understand the innate differences between fixed and variable rates then the below breakdown will help you make the best-educated decision.
First, let’s address if it’s worth it for you even if the direst of rate hike predictions come true.
When should you not consider a fixed rate, no matter how high variable rates go?
Answer: If you think you are part of the 60% of Canadians who break their mortgages early and are charged $15,000-$50,000.
Below are the most common reasons people break mortgages early:
Refinancing: People need cash for emergencies, debt consolidation, or investment opportunities and need to pull equity out of their home. Unless your mortgage has a Home Equity Line of Credit (HELOC), you will need to break the mortgage.
Lower Rates: People who got mortgages in 2018 had rates over 3% and suddenly saw those same rates go down by 50% in 2020 - would you want to keep paying double what is on the market? To switch to a lower future rate with the same lender or elsewhere, means breaking the mortgage.
Home Sale or Divorces: A divorce usually means needing to sell the home which, unless it’s portable, means you need to break the mortgage.
Based on the above realities, borrowers who admit they might do any of the above within their term, usually keep a variable rate no matter how high it increases. One client of mine had a $129,000 breakage fee for trying to switch from a 3% rate to a 1.20% - suffice to say she was trapped.
Immediate Monthly Savings: Break your variable mortgage for a much lower variable rate
Another reason why many people stay strong on holding their variable is that if a better variable rate comes up, they can easily break their mortgage without big penalties. You pay a very low penalty of 3-months worth of mortgage interest charges which can be added to your new mortgage so you don’t pay it up front.
If you’re holding onto a variable mortgage and have a rate over 1.45%, do the math on how much you can save for the record low rates that exist now - use this excel template.
Example: Save $283 a month in interest charges if you break a 2% variable rate for a lower one of 1.15%. Below is the math on a $400,000 mortgage:
Monthly Cash flow savings: ~$160/month ($9000 savings on a 5-year term)
Monthly interest savings: ~$283/month ($16,980 savings on a 5-year term)
See video example here to follow the above math.
Even if your rate is 1.45% now, you'll see that you still save ~$100 on monthly interest charges.
When should you consider a fixed-rate mortgage?
If you are the kind of person who likes to “set it and forget it” and you deem you are not likely to break your mortgage, fixed might be optimal for you.
If you’re the more analytical type who just wants to run the numbers, you’ll want to watch the below video and download this excel spreadsheet to run scenarios of costs given different layers of interest rate hikes.
Calculating fixed rates vs. worst case scenario variable rate increases (See 9-minute video below)
Excel calculator to estimate your potential break-even point on fixed vs. variable
Given that at the time of this article in January 2022, some of the lowest variable and fixed rates are 1.20% and 2.50% respectively, there is a gap of as little as 1.30% between the two types of rates.
To decipher which rate type is most worth it, you need to think about whether that predicted 1.75% variable rate increase will happen by the end of 2023. Remember you’re saving quite a bit of money today at 1.20% so as the gap of ~1.30% closes, you should consider the savings per month. If you like to invest, think about what the potential gains will be from putting this money saved each month aside.
Cash Flow vs. Interest Rate Impacts When Variable Rates Increase
When there is a rate hike, most people will focus on their increasing monthly mortgage payments but, they should not overlook the true increase in costs which is calculated by the interest portion of your mortgage. Monthly mortgage payments are broken down into a principal portion which converts to you gaining equity in the home. The other portion is a pure interest which goes to the bank and can be thought of as throwaway costs.
Example:
A homeowner has a five-year variable rate mortgage of 1.20% on a $750,000 balance with a 25-year amortization. They would see monthly mortgage payments rise from $2,894.96 to $2,981.94 after a .25% variable rate hike. This $86.98 cash flow mortgage increase is what you will feel immediately but you need to consider that there is a disproportionate increase in pure interest charges compared to how much less principal you pay - see the breakdown below.
A) 1.20% rate on $750,000: $2,894.96 Monthly Mortgage $2,894.96 Monthly Mortgage is broken down by $2,144.96 paid to principal and $750 in interest
B). An increase of .25% occurs
C). 1.45% rate on $750,000: $2,981.94 Monthly Mortgage $2,981.94 Monthly Mortgage is broken down by $2,075.69 paid to principal and $906.25 in interest
The overall monthly principal payment at the 1.45% rate increase is decreased by $69.27 which is counterintuitive since the rates just went up. However, it acts as a buffer to soften the blow of the $156.25 increase to the interest portion of the mortgage.
If you get nervous about your monthly budget fluctuating, some lenders will keep monthly payments the exact same, even if variable rates sky-rocket. The catch is that you pay less principal and much more interest on your monthly payments.
THE BOTTOM LINE
Whether you lock in your variable to a fixed rate mortgage now, later, or ever, depends on a variety of factors that vary from person to person. If you think you might be part of the 60% of Canadians who break their mortgage early, holding onto a variable might be prudent. As was illustrated, holding a variable lets you be proactive and switch to a lower mortgage rate with a very small penalty. Switching to a fixed rate depends on your anxiety levels and your prediction of how much variable rates will rise. Most experts believe variable rates will rise by 1% in 2022 and another .75% in 2023 so if you believe that, you’ll need to run some numbers and see if today’s savings with a variable might offset future losses.
Do you want to learn more about mortgage financing in Canada? Level Up Mortgages supports homebuyers and homeowners in attaining success in their mortgage journey with mortgage strategy, digital mortgage education, and introductions to all the other experts you need to succeed in home buying and your personal finance. To assist homebuyers and homeowners in purchasing or refinancing new homes, we work with premier banks and best-rate mortgage lenders in British Columbia and Ontario. Get in touch with us today!
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Paul Davidescu (www.levelupmortgages.com)
604-809-3188
paul(at)levelupmortgages.com
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