If you have a variable rate mortgage, you belong in a highly respectable group that includes most of my clients and myself. At this time of rising rates, I’m frequently asked whether to lock in the variable rate into a fixed. The math is simple: every 0.25% prime rate increase, will result in a $13 increase (per month) for every $100,000 in mortgage. Is this unbearable? Is this $13 a true motivation to convert your cheap variable rate into the fixed rate, which is 1% higher? Is it worth paying a penalty that is eight to nine times higher if you wish to walk out mid-term? My answer is no — the cost of having a fluctuating, variable rate mortgage is minor in comparison to the benefits it offers.
Let’s say I have a variable rate 400K mortgage. What will happen to my monthly payment?
I see the variable rate mortgage as one of the leading financing products for years now. It is true that for a $400,000 mortgage, every increase of 0.25% in the prime rate will cost you $54 more every month, but please keep in mind you started with paying at least $200 less than those who took a fixed rate mortgage at the same point of time. You still have significant savings over them.
Why all this emphasis on the variable rate penalty versus the fixed rate penalty? I don’t intend to break the mortgage, nor pay a penalty
You’ll be surprised to hear that although 99.8% of clients are sure that they will keep the mortgage for the full term and definitely avoid paying any penalty, most will break it midterm. The statistics show that 70% of Canadian mortgage holders break their mortgage midterm and pay huge penalties if they took a fixed rate mortgage. This is the way banks make their profit on mortgages. For instance, the penalty for a fixed rate 400K mortgage would be around 18K, while with a variable rate mortgage they would end up with only $2000 in penalty.
So why do 70% of Canadian mortgage holders break the mortgage contract and pay penalties?
Typically, Canadian mortgage holders break their mortgage due to family-related reasons
- The family moves to another neighborhood, city, or province
When moving from one house, city or province to another, you’ll notice that because of the new federal rules, the mortgage you thought to be portable is not easily transferable. If you took your mortgage with a credit union and you wish to move outside of their lender’s designated area, your mortgage will no longer be valid outside the defined area. In these cases, you’ll have to payout the mortgage and take a new one. It will involve paying a penalty — and as mentioned, the penalty for variable rate mortgages is much cheaper.
- Because a couple goes from living in two households to a single one
In many cases, when the couple decides to move in together and combine their households, they find themselves with two houses instead of one — this means a redundant house and mortgage. Sometimes they decide to sell the two small houses and purchase a new one that can accommodate future family plans. In both cases they will need to pay off mortgages that are not easily portable. A variable rate mortgage will reduce these costs significantly.
- Because the couple gets separated
Unfortunately, the divorce rate in Canada is more than 40%. With these statistics, new financial arrangements turn out to be costly if the couple holds a mortgage that does not have the variable rate. The profits after selling the shared home are split after paying a big penalty to dissolve the mortgage. Even if one spouse aims to buyout the other’s portion of the property, these penalty costs remain. The penalty associated with a fixed term rate mortgage will eat a big portion of the split equity.
- Because one spouse fell ill or passed away
When this happens, the family may face the difficulty of paying the monthly mortgage payment. In case the couple declined the mortgage insurance offer (not recommended!) the family might find themselves needing to sell, move to a smaller house, or sometimes rent. It is essential that when selling and breaking the mortgage the costs are as small as they can be. This can only be achieved with the variable rate mortgage.
- Because one of the family members asks to be removed from the title
20% of mortgage holders in Canada got the help of a family relative or their children to get approved for their mortgage. Usually the owners aim to release the guarantor as fast as they can, so they will be able to purchase their own house and get their own mortgage. In some cases, removing the co-applicant or guarantor from title will be only a legal matter. Other instances involve breaking the mortgage mid-term and setting new financing in its place. Again, variable rate mortgages are the cheapest solution when needing this flexibility.
They also do it for a new financial organization and planning
- To pull some equity and invest
In the past three years, houses went up significantly in value. Although the new mortgage rules make it harder to pull equity, there is still room to do so. If you are looking to pull equity and purchase more investment properties, you cannot limit yourself to the time the mortgage term ends. Your timing needs to be determined by the real-estate market and its opportunities. Any of our clients that have plans to purchase more real-estate are advised to take the variable rate mortgage that will allow more flexibility at minimal costs.
- To pull some equity and pay debts
The rising value of your home is also a means to consolidate high-rate credit card debts in the range of 19-22% into a mortgage at 3.5%. This strategic act has great potential to get you out of the debt cycle. Again, the cost of this would be much cheaper through a variable rate mortgage.
- To improve your mortgage terms
When working with a good mortgage broker you may expect a phone call advising you that it is the time to break your current 95% mortgage and move to a new one that reflects 80% of your rising house value. This will allow you to move from a 25 year amortization to 30 years, relieving your monthly expenses. In the past we have done this to get a better rate or to secure another five years of the last rate deal. If you have a penalty with a fixed rate you won’t be able to take advantage of any new situations.
So back to the question we started with: is it the right time to lock into a fixed rate? Usually, we would say no. However, if you suffer from the possibility of fluctuation and the worry would not let you sleep at night, you can convert your current variable mortgage into a two or three-year fixed rate mortgage. This way you’ll be partially protected from the higher penalty choice that most will pay at the third or fourth year for the term. It is important to review the pre-payment options, as they significantly influence the how pricy your mortgage will be.
To conclude: the cost of your mortgage won’t be affected much by how good the rate is — whether its variable or fixed. A proper planning and guidance through the fine print will determine how much money you spend.