One of the biggest draws of
variable-rate mortgages
is that they give you options.
For starters, variable mortgage prepayment penalties are generally cheaper than their
fixed-rate counterparts
.
They’re typically just three months’ interest, rather than the dreaded “interest rate differential” penalties that can ambush you when breaking a fixed mortgage early.
On top of that, almost all variable rates let you lock into a fixed rate “free” of charge.
“Free” gets the scare quotes here because, in practice, this feature comes with a very real cost, and here’s why.
Rate lock timing is hard
Rate lock features give borrowers a sense of control, but that control is often a mirage.
Take today’s case, for example. We’re staring at a looming war-driven spike in inflation that even the Bank of Canada admits is coming.
“Central banks always
hike interest rates
during an oil shock,” noted National Bank of Canada’s chief economist Stéfane Marion at the bank’s Financial Services Conference on Wednesday. (He was referring to major oil shocks here, of which there have been eight since 1956. History does enjoy a rerun, doesn’t it?)
This pattern is one reason why derivatives markets are now pricing in three Bank of Canada rate hikes over the next 12 months.
The problem is, fixed
mortgage rates
are linked to Government of Canada bond yields. And those yields largely reflect where the market expects policy rates to go.
Since the market expects higher policy rates, bond yields are climbing.
As bond yields rise, fixed mortgage rates follow them up the ladder.
So far, average five-year fixed rates are up 25 to 30 basis points since the start of the war, according to MortgageLogic.news’s latest rate survey.
You can still find a few deals, however. For instance, some default insured offers are still below four per cent — probably not for long.
The trouble is that lenders typically won’t give you those rate deals if you’re already under contract with them.
If they see you wanting to lock in — knowing that leaving will cost you a penalty — most will cheerfully quote you an above-market rate, hoping you don’t balk.
Instead of that 3.99 per cent steal you just found for a new insured fixed, the lender might offer something like 4.39 per cent. Tack on at least 20 more basis points for an uninsured mortgage.
What’s 40 basis points between friends?
Well, it costs about $5,600 extra over five years on the average Canadian mortgage, which is roughly $300,000.
That’s probably the minimum slippage most people face when locking in a variable to a fixed, simply because they wait too long.
Borrower psychology can be a detriment
All of this might be unsettling to any tight-budgeted borrower sitting on a floating-rate mortgage.
No wonder, then, that outside of the pandemic period, Google Trends shows
related to locking in a mortgage are now the highest in at least 17 years.
But many folks are prone to gamble. They figure they’ll monitor the market, see how the war shakes out and whether yields move higher before committing.
That’s a swell plan if timing cooperates.
The problem is, bond markets price in hikes several weeks before your lender’s prime rate ever moves.
Right now, traders imply a much better than even chance of a
Bank of Canada
rate hike by July 15.
Canada’s five-year government yield started pricing in more tightening over three weeks ago, shooting up 53 basis points since the war began.
Now, a half percentage point is no joke to borrowing costs. And by waiting longer, a borrower could see that aforementioned 4.39 per cent offer potentially inflate to 4.59 per cent or more.
All of this is why many borrowers who are on the fence about locking in feel one of two emotions:
1. Panic for missing the boat, which often leads them to throw in the towel and lock in a half point (or more) too late.
or
2. Deer-in-headlights syndrome, which often leads to a decision to ride out the Bank of Canada rate increases and “see what happens,” only to remorsefully watch the Bank of Canada ram rates higher.
Both tendencies show up like clockwork in every rate-hike cycle.
Of course, predicting rates is a marvellous way to discover that the rate market has a dark sense of humour.
Really, the only shot one has of locking in at the “right time” is to be early and bet that they’re
reading inflation correctly
.
Historically, mortgagors have the most success locking in:
- After a big rate-cut cycle
- After rates have bottomed out for a while
- As inflation shows signs of heating up again
- With two-year Canadian bond yields rising meaningfully above the Bank of Canada’s overnight rate.
When a supply shock like the current one hits, it can pour gasoline on inflation practically overnight, improving rate lock odds even further.
Some rear-view mirror analysis
What goes up usually comes down, and that applies to interest rates, too.
“When
oil shocks end
, bond yields have historically declined sharply,” Alpine Macro’s chief global strategist Chen Zhao said in a recent report.
So, if we do get a few years of rate pain, one should expect it to ease given the recession risk that follows.
Factors like this are why variable rates are best viewed as a roller coaster where the five-year average matters more than the stomach-churning peaks and valleys.
And sometimes, that roller coaster still averages out to a much higher rate than a boring old fixed mortgage. In those cases, hindsight shows how paying for protection would have paid off.
Had you floated your mortgage a few months before the last hike cycle — say, January 2022 — you could have scored a 1.39 per cent variable rate.
That was a whopping 150 basis points lower than the leading 2.89 per cent five-year fixed at the time.
Many of us vividly recall the commentary back then insisting that the upfront variable discount would cushion borrowers through the coming tightening cycle — especially after all the central banker handwaving about “transitory” inflation.
Five years later, borrowers who paid that 1.50 percentage point “insurance premium” for a five-year fixed — and who rode out their terms — were drastically further ahead, to the tune of almost $23,000 on a $300,000 mortgage.
Rate insurance is kind of like home insurance in that sense. You resent every payment until the day your roof caves in, and then you’re a believer.
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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