With all evidence suggesting interest rates are on the decline, why are borrowers still afraid of variable rate mortgages?
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For a seemingly endless 27 months, from March 2022 to June 2024, those with variable-rate mortgages watched in dread as Canada’s benchmark prime rate climbed a mountain and then stayed at its peak.
Now we’re on the back side of that mountain, with two rate cuts in the bag and another coming September 4.
However, the clearest sign that global rates have peaked will come out of Jackson Hole, Wyoming, on Friday. That’s when the world’s most powerful banker, U.S. Federal Reserve chair Jerome Powell, speaks next. He’s expected to signal a 25-basis point rate cut on September 18.
This comes after Fed minutes, released Wednesday, revealed the “vast majority” of committee members supported a cut in September, barring inflationary economic data surprises. A Fed easing cycle would coincide with further Canadian central bank cuts as well.
Still, despite the favourable odds, most borrowers aren’t rolling the dice with a variable mortgage. They either lack the nerve or, as we’ll see below, the option.
Recent data from StatsCan reveal a landslide preference for the security of five-year fixed rates — more than 10 times as many borrowers are choosing a five-year fixed (or longer) over a variable. But why?
With access to information so plentiful, anyone who Googles rate history and academic research can see that five-year fixed rates rarely win when we’re near the top of a rate cycle.
Yet, most folks still avoid variable rates like they’re a blind date set up by an ex. Here’s why:
#1. Fear
People know rates have peaked because the Bank of Canada has cut them twice already. But they don’t know how long that peak will last.
Historically, it’s rare to see:
(A) the Bank of Canada begin a rate cut cycle after rates surpass their 10-year average, only to then see…
(B) rates boomerang to new heights within a couple of years.
It happened in the disco days of the late 1970s/early ‘80s, but that was a different era in terms of inflation, monetary policy (there was no direct inflation targeting back then), debt loads, energy independence, technology, financial markets, demographics, and so on.
Nonetheless, the financial colonoscopy variable-rate borrowers were subjected to in this recent rate hike cycle is still too vivid. For many, variables seem too precarious, despite their historical dominance when Bank of Canada rates are this restrictive.
#2. Difficulty qualifying
The government’s ‘stress test’ makes qualifying for a variable rate mortgage harder than qualifying for a fixed one.
For example, if you pop into any bank and ask for a five-year fixed, they’ll make you prove you can afford a rate of around 6.90 per cent or less. That’s 200 basis points above their actual rate.
But if you ask for a variable mortgage, they’ll make you prove you can afford a rate near 7.90 per cent.
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That extra percentage point on the qualifying rate means you have to show materially more income to be approved for a variable mortgage, all else equal.
Effectively, government policy is trapping folks with above-average debt service ratios into fixed mortgage terms that may not be in their best interests. Welcome to the quirks of Canada’s mortgage market.
#3. Sticky payments
Most variable-rate mortgages have payments that don’t move when the prime rate falls. For example: “With CIBC’s variable rate mortgage product, monthly payments are fixed, so as rates rise or fall, the amortization period will either extend or shorten,” explains CIBC Senior Consultant, Public Affairs Josh Burleton.
In a case where a borrower has a prime minus 0.75 per cent variable rate with 20 years remaining, Burleton says, and rates are cut 25 basis points, “because there is no payment change, there would be a $20 reduction in interest per monthly payment in light of the rate decrease.” That is per $100,000 of mortgage balance.
An interest reduction is dandy, but with Canada’s high cost of living, many are hoping for a payment decrease too. They won’t find that at four of Canada’s five largest banks. Nonetheless, some bank customers don’t want to switch lenders, and others might not know they can get an adjustable rate that drops with prime elsewhere. Hence, they just go with a fixed.
Mortgage tip: Scotiabank is the only Big Five lender that offers payments that fall with every drop in the prime rate. And there are many other banks, mortgage finance companies and credit unions with this feature. Mortgage brokers know who they are.
An educated bet
Forward rate markets, where traders bet on future rates and hedge interest rate risk, suggest we’ll see significantly lower rates by the time this Bank of Canada cutting cycle is over.
Data from CanDeal DNA show markets are betting on a 200 basis point plunge in Canada’s overnight rate. That implies a drop in Canada’s benchmark prime rate from 6.70 per cent today to 4.70 per cent by 2026.
If variable borrowers hit that jackpot, the math leaves little doubt that floating a mortgage would save them more.
The problem is, betting on the market is like trusting trusting a compass in a magnet store. It’s often wrong, and in this rate cycle, there are risks we haven’t seen before: a disregard for balanced federal budgets, inflationary deficit spending, risk of housing re-inflation, persistently high services inflation, de-globalization, etc.
And with some economists predicting we’ll escape this easing cycle without a recession, it’s possible rates won’t drop as much as the market expects.
Regardless, most well-qualified risk-tolerant borrowers should take their chances on a floating rate anyhow. Even with mere 100 bps drops versus 200, variables won’t break the bank compared to fixed. Moreover, you’ll get a cheaper prepayment charge with a variable if you want to break the mortgage and/or refinance before maturity. Plus, you can switch to a fixed rate anytime penalty-free.
Robert McLister is a mortgage strategist, interest rate analyst and editor of MortgageLogic.news.
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