Should you go for a variable rate mortgage or go for the old reliable five-year fixed rate? How can you ensure your payments are predictable while repaying your principal? Are static payments a good idea?
The mortgage questions are overwhelming at the best of times for homebuyers and refinancers, but especially now that the Bank of Canada has aggressively raised its benchmark interest rate to 2.5% from 0 .25% over the last six months.
While most economists expect another rate hike in September, the housing market is expected to cool further in 2022.
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But even though many Canadian markets are seeing substantial price declines from the February 2022 high, higher rates are limiting the amount of mortgages banks offer buyers.
Personal finance expert Rubina Ahmed-Haq told Global News ‘ The morning show this week that buyers waiting for further price drops should factor higher rates into their calculations if they’re trying to time the market.
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“With higher interest rates, you’re going to have a higher cost of borrowing, so you have to take that into account when buying your home,” she said. “So if you wait a year, interest rates could be higher, which means your mortgage payments on the same loan amount could also be higher.”
Here’s how to choose the right type of mortgage and do your own math to make sure you’re prepared for rising rates when you sign up for your new home, according to experts.
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Variable or fixed mortgage?
One of the first choices when taking out a mortgage is whether it’s fixed – the same rate for the duration of your term – or variable, meaning it will rise and fall immediately depending on the Bank of Canada’s key rate.
Fixed rates are tied to longer-term bond yields and have always been the most popular option for Canadian mortgage holders.
But when the central bank cut rates drastically at the start of the COVID-19 pandemic, many buyers opted for an adjustable-rate mortgage because it was the lowest possible rate. Low rates have made larger mortgages more affordable, providing many people with the opportunity to access homeownership and spurring a lot of activity in the Canadian housing market over the past two years.
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According to the Canada Mortgage and Housing Corporation, the majority of buyers or homeowners renewing their mortgage switched to a variable mortgage in the second half of 2021, but this trend has reversed as the era of lowest interest rates ended.
Fixed-rate mortgages accounted for 49% of all home loans in May, according to the latest Bank of Canada data, compared to 43% in March – the lowest proportion since the central bank began tracking data in 2013.
The best discounted five-year fixed rate is 4.24%, Reuters said this week, while the floating rate is 3.5%. It’s the narrowest gap since September, another factor pushing more borrowers toward the former.
James Laird, co-founder of mortgage rate comparison site Ratehub.ca, said the trend continues, estimating that fixed-rate mortgages accounted for more than half of all new home loans in July.
A fixed-rate mortgage protects buyers against further rate hikes over the term, but the predictability risk is that those monthly payments also won’t drop if the Bank of Canada’s interest rate drops, such as they would do that with a variable rate mortgage.
“If (current economic conditions) are keeping you up at night, the best thing to do is get a fixed rate mortgage and forget about it,” Laird told Reuters this week.
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Static payments offer a combination of fixed and variable payments
Rising rates aren’t just a concern for homeowners — investors and real estate professionals who rely on the industry also face uncertainty.
Nick Hall, a mortgage agent in Toronto, used a special variable rate loan with “static” payments in a few of his investment properties.
In these cases, the amount paid on a home loan each month does not change even when the interest rate rises, so a homeowner ends up paying less than their primary mortgage amount and more interest.
Hall offers the hypothetical scenario of a monthly payment of $3,000 split half between principal and interest on the loan. As rates rise on a variable rate mortgage, a static payment is steady at $3,000, but only $1,000 of that could go to paying down principal while the rest goes to higher interest.
The downside is that as central bank rates rise, more of your monthly payments are spent just on interest on your loan rather than paying off your mortgage. This means that it may take longer to pay off the mortgage, which lengthens the “amortization period”, as it is called.
But the investors Hall partners with like to see “certainty” on their balance sheets, he explains, so a fluctuating monthly payment isn’t ideal for their cash flow calculations.
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Although he is currently paying off less of his mortgage principal, Hall still believes in the variable-rate model, believing that when rates come down over time, it will outperform the safer fixed-rate game.
“Yeah, it’s not ideal, but it’s also temporary,” he says. “Real estate is a long-term game. This is not day trading, you are not trading stocks.
Daniel Foch, a broker in Keswick, Ont., who co-hosts a real estate podcast with Hall, says many Canadians who entered the housing market during the pandemic with low variable rates are likely to wake up abruptly as the interest rates rise.
Even in his own case, two of his variable-rate properties no longer have positive cash flows because rates have gone up, he says.
He says a lack of education about mortgages in Canada could be part of the “financial stress” households are feeling as rates rise.
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“I really think that could be a big part of the problem. I would say financial education is probably not what it should be in Canada,” says Foch.
Before a new buyer locks in a variable mortgage rate, he recommends running a few different scenarios.
Foch says you should factor your expected maintenance costs, property taxes and other regular fees into your monthly mortgage payment based on your proposed rate, but also see how that figure would change if rates go up at the “worst case scenario” or if you opt for the best fixed rate offered instead.
He also advises buyers to zoom out and look at the cost of the entire mortgage with the interest rate added on top to see how different scenarios would play out not just over the next five years of your tenure , but also over the full 25 years or however long you hold the mortgage.
Once you’ve done the side-by-side comparisons, you can determine if this mortgage product fits your risk tolerance.
“You can start to understand whether or not it makes sense to buy with some type of interest rate, (or) whether or not you should maybe wait for prices to come down, which seems to be happening at the following these rate hikes,” he says.
– with files from Anne Gaviola of Global News and Reuters
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