An aerial view of the home is shown in Calgary on June 22, 2013.Jonathan Hayward / The Canadian Press
The Bank of Canada raised its benchmark rate by a full percentage point on Wednesday, the most aggressive rate hike since 1998 and an even bigger jump than Bay Street investors and economists expected. This is the fourth consecutive rise in interest rates since March, as central banks around the world are trying to curb rampant inflation and slow the pace of consumer price growth. The Bank of Canada’s policy rate now stands at 2.5 per cent.
The rapid rise in borrowing costs is already putting pressure on certain segments of the Canadian economy, most notably the housing market, which has experienced falling prices and a slowdown in recent months. For home buyers, being able to pay mortgage payments is increasingly becoming an additional hurdle to buying a property.
The impact that interest rate hikes have on homeowners and home buyers depends on whether they have a fixed or variable rate mortgage. Those with variable rate mortgages that adjust to the preferential rate are more exposed to benchmark rate increases and may be concerned about current trends.
With that in mind, here’s what you need to know about how mortgage rates will be affected by rising interest rates.
What is a variable rate mortgage?
A variable mortgage rate fluctuates based on the so-called preferential rate, which benchmark lenders typically adjust based on one-day rate movements that set trends for the Bank of Canada.
Lower rates on variable rate mortgages have attracted home buyers in recent years. In April, they accounted for 37% of new secured mortgages, according to the latest data from Statistics Canada and the Bank of Canada, compared to just 5% of mortgages in January 2020.
What is a fixed rate mortgage?
A fixed interest rate mortgage typically blocks payments for a specified period of two to five years. Fixed rates are usually higher than variable ones, but they offer reassurance to homeowners that their mortgage payments will be steady for years to come.
What is Canada’s preferential rate and how will it affect variable rate mortgages?
The Bank of Canada’s increase was due to the type of policy, which works as a target for the daily one-day rate, which in turn is the basis for variable-rate mortgages.
The principal rate is the annual interest rate used by Canada’s major banks and financial institutions to set interest rates for variable-rate loans and lines of credit, including variable-rate mortgages. As political rates go up, preferential rates go up, which ultimately increases the interest rate you pay on your loan. The main rate in Canada is currently 3.70 per cent.
Will mortgage payments increase due to the Bank of Canada rate hike?
When interest rates go up, homeowners pay more interest. However, not everyone will see their monthly payments increase when rates go up.
Some variable rate mortgages keep payments stable, up to a certain threshold, known as an active rate, even when the interest rate goes up. Instead, these borrowers pay more interest and less on the principal monthly, and see their repayment period extended, meaning it will take longer to pay off the mortgage.
But if interest rates continue to rise, interest payments could rise when the activation rate is exceeded.
What is an activation rate?
The “active rate” is the level of interest rate that, when exceeded, causes the monthly installments of the mortgage holder to change. The rate of activation has been largely ignored for decades, because the last time Canadians had to deal with rapidly rising rates was in the late 1970s.
Now that interest rates are rising, borrowers are approaching their active rate, a level at which their usual monthly payments will not be enough to cover the interest for the period.
The exact activation rate is different for each mortgage holder and depends on the size of your loan, the amount of your monthly payment, the interest rate on the mortgage, and the length of the repayment period.
Can I convert my variable rate mortgage to a fixed rate?
You can’t go from a fixed rate to a variable rate without breaking the mortgage contract (which carries a penalty).
However, it is possible to go the other way. You can block a variable rate mortgage to a fixed rate one at any time, without breaking the mortgage contract, and if you break the contract with a variable rate, the penalty is often much lower.
Do I need to convert my variable rate mortgage to a fixed one?
Variable rate mortgages are usually cheaper than fixed rate mortgages, in which the borrower pays the same interest rate during the term of the loan. The most common fixed-term rate (five years) rose to 4.41 per cent in early June from 2.21 per cent the previous year, according to data from the Bank of Canada. Meanwhile, the variable rate mortgage rose to 2.72% from 1.63% in the same period. The Bank of Canada’s new interest rate hikes will be reflected in floating rate mortgages and new fixed rate mortgages.
Switching from a variable rate mortgage to a fixed rate mortgage usually requires you to pay a penalty equivalent to three months of interest, depending on the lender. However, you may not be able to lock in at the most competitive fixed rate available, and the terms of your mortgage may remain the same. This means that the fixed rate you are converting will only be valid for the remainder of your current term and you will be required to renegotiate this rate once your mortgage is pending renewal.
That said, the risk of getting stuck, especially with a five-year term, is that you can get stuck paying a lot of interest if trends change. Staying with a variable rate means you’ll use lower rates once inflation has peaked. If Canada goes into recession, interest rates could fall rapidly. It is also expensive to switch from a fixed rate to a variable rate mortgage, as this carries a higher penalty.
The most important factors to consider when making the change are your risk tolerance and the size of your mortgage. In general, blocking is less attractive when variable rates are significantly lower than fixed rates; however, it’s important to consider your ability to keep up with your variable mortgage if rates continue to rise. In addition, interest rate hikes have a lesser impact on homeowners with variable rate mortgages that are small or that have been paid off significantly.
Featuring files from Erica Alini, Rob Carrick, Mark Rendell and Rachelle Younglai.
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