Usually, changing from a variable rate to a fixed rate before the mortgage deadline means signing up for a higher rate. Fixed mortgage rates are usually higher than the variables, because people are willing to pay more for the comfort of knowing that their interest rate will not change.
For months, however, fixed mortgage rates fell below variable rates, a rare occurrence that reflects investor concerns about the possibility of a future recession in the US and Canada.
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For example, the lowest nationally available five-year fixed rate for a conventional mortgage today is 2.79 percent, according to Robert McLister, founder of RateSpy.com rate comparison site. The lowest variable rate for a five-year period is 2.89%.
This means that variable rate holders with a five-year mortgage term can set a fixed five-year rate that is lower than the current rate. And what is better than getting a better rate and the peace of mind of a fixed mortgage payment?
Not so fast, some mortgage brokers say. Locking a lower rate does not necessarily save you money.
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The math of 'lock' – three scenarios
To illustrate the concept, Toronto mortgage broker David Larock released the figures for three future scenarios in a recent blog post.
Take three homeowners, let's call them Joe, Jane and Rahul – each with a pending balance of $ 400,000 and two and a half years for the five-year variable rate mortgage.
Joe's floating rate is tied to a 0.6% discount from the base interest rate, a benchmark rate used by lenders. Based on the current 3.95% base interest rate, Joe's rate is 3.35% today.
Jane got a slightly better deal with a prime variable rate minus 0.85%, which means her current variable rate is 3.1%.
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Rahul has the best rate – prime minus one percent – and is paying a 2.95 percent rate.
All three could switch to a flat rate of 2.79% today. But should they?
Larock's math shows that blocking may not be a good idea if the economy gets worse.
Scenario One: The economy slows but then picks up
In the first scenario Larock envisioned, interest rates initially fell by 0.25% in early 2020 as growth in the US slows, raising concerns about Canada's own economic health. Fortunately, however, things happen again after the US federal elections and rates rise by 0.75% by 2021.
In this scenario, the lock would save money for all three variable rate holders in our example. However, if they had to break their mortgage and pay $ 3,100 in fines to access a low 2.79% flat rate in five years, only Joe would come out ahead.
Borrowers can convert their variable rate into a fixed rate at their existing lender, which avoids fines. However, they will be "at the mercy of the lender" who may not offer them a competitive rate.
Breaking the mortgage means becoming "a free agent" able to buy the best rate available, Larock said. The problem, however, is that you must pay a fine and, if you are applying for a new loan with a federally regulated financial institution, qualify for the stress test with the new lender.
Scenario Two: The US Dives Into Recession
In this scenario, Larock considered what might happen if the US economy plunged into recession, dragging Canada's economy as well. The Bank of Canada may reduce its interest rate by 0.75 percentage points from 1.75% to 1% in several cuts throughout 2020. However, lenders pass on only a few of these savings to consumers, as they did when O Canada's last central bank cut rates in 2015. As a result, variable rates fall only 0.45% over the year.
In this scenario, the difference between arresting and staying in place would be minimal for all three borrowers two and a half years later. However, by switching to a five-year fixed rate, they will still have half of the mortgage term to reach 2.79% by the time more competitive rates may be available, Larock noted.
"Standing still now, even at a higher comparable rate, would probably still make the three long-term variable rate borrowers better."
Scenario Three: A Severe US Recession
If the US economy plunges into more serious funk in the coming years, the Bank of Canada could be forced to lower its base rate by a full percentage point, with lenders passing on 80 percent of the cost savings, Larock writes.
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In this scenario, it would be best for all three borrowers to keep their rates variable. Not only would they save interest if they were firm, but their mortgages would be renewed at a time when interest rates were likely to be very low, according to Larock.
“In this situation, it would be better for variable rate borrowers to stay on course. Time would be on their side.
How to decide if you should change from variable to fixed
The bottom line is that if interest rates start to fall again, existing variable-rate mortgage holders who stand firm could move ahead, according to Larock.
This could very well happen in the near future. The fact that fixed interest rates are currently below floating rates means investors expect short-term interest rates to fall, McLister said.
Historically, variable rates provide savings compared to fixed rates most of the time, he added.
However, "when it comes to assessing direction, what we know for sure is that we know nothing for sure."
There are other ways to assess whether switching to a flat rate makes sense. For example, if your financial situation deteriorates and settles at a fixed rate would lower your anxiety levels, the change may be worthwhile, McLister said.
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On the other hand, if you are simply trying to gauge the market, "this is crazy and you probably weren't prepared for a variable in the first place," McLister said by email.
Still, "if you are stuck with an expensive variable (eg prime – 0.60%), you need to assess whether it is worth paying a fine for refinancing for a much lower rate. Often it is.
But even so, there are exceptions. A borrower with a relatively expensive variable rate who still has little time left to repay may be better off, Larock said.
For example, someone with only six months left of the mortgage term could apply for a flat rate within 120 days of the renewal date and ask the lender to keep it, he added.
On the other hand,
"If I had a prime minus variable rate (0.60%) and four years left in my tenure, then the cost of that uncompetitive rate would be increased by the time remaining in the mortgage. "
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