Should Canadians consider locking in fixed rates?
If you're feeling financially stretched due to the seven (yikes) interest rate hikes by the Bank of Canada since March 2022, you’re not alone. And you might be considering switching to a fixed-rate mortgage. A little stability in these choppy waters has its appeal. But before you make any decisions, allow us to help you chart your course. It's essential to evaluate all the available options and weigh the pros and cons before sailing toward fixed-rate waters.
Variable-rate mortgages come in two types: fixed payment and adjustable rate mortgages. In a fixed payment variable-rate mortgage, the monthly payments stay the same each month. As interest rates go up (which after this hike cycle, we can confirm they do in fact go up), a larger portion of the payment goes towards the interest instead of the principal, which prolongs the amortization schedule (the time it takes to pay off the property). When the interest payments surpass the total payments, it triggers the margin call, which requires the lender to take action.
Adjustable rate mortgages are more complicated, with rates fluctuating depending on the prime rate. Homeowners are not likely to feel the effects of interest rate increases right away, but they will be reflected in their semi-annual mortgage payments. When the prime rate changes, so does the payment.
In the previous decade, a considerable number of people chose variable-rate mortgages, believing that it would save them money. They thought they could handle any changes over the mortgage term. However, the current situation has shifted, and those who opted for variable rates now pay more than the fixed rates initially offered. While sticking with a variable rate might be advantageous if you need to break your mortgage before the term expires, it might be necessary to switch to a fixed rate if the fluctuating monthly payments are causing you financial distress.
The long haul.
Jova Xu, a Realtor in Vancouver with Jovi Realty, suggests that breaking a fixed-rate mortgage involves penalties of three months' interest or the Interest Rate Differential, whichever is higher.
When it comes to breaking a variable-rate mortgage, a penalty of three months' interest is typically imposed. In cases where there's a chance of selling the house before the mortgage term is up, switching to a fixed-rate mortgage might not be the best option. Moreover, during a declining interest rate environment, locking into a five-year fixed rate and risking being charged a penalty in the future when rates are lower might not make financial sense.
Although interest rate hikes can seem significant in the short term, they are unlikely to be a game-changer over the course of a 25-year mortgage amortization or one's lifetime. A 1% difference in mortgage rate on a $500,000 mortgage balance equates to $5,000 per year. It's crucial to evaluate one's unique situation and weigh the pros and cons of committing to a fixed mortgage rate.
An interesting conclusion.
After eight consecutive increases, the Bank of Canada has decided to maintain its key rate at 4.5 percent, citing the continuous decline in year-over-year inflation since it peaked at 8.1 percent in June last year.
While many economists and financiers believe that the policy rate will remain steady in the next announcement due to the country's resilient economy and tight labour markets, concerns about financial stability, stemming from the failure of many banks worldwide, have overshadowed worries about price stability. As a result, it's predicted that interest rates will rise.
The Bank of Canada's decision to pause marks it as the first major central bank to cease interest rate hikes, putting it on a different path than the United States. However, this could result in inflation as the price of most imported goods increases.
Although December's year-over-year inflation was 6.3 percent, the data reveals that prices skyrocketed until June, particularly in the food, shelter, and gasoline sectors, which accounted for 75% of the price surge. Gasoline prices, in particular, increased by 48 percent and contributed to 40 percent of the overall inflation during the first half of 2022.
The tight labour market is the Bank of Canada's biggest concern. The unemployment rate remained close to its historic low of 5.0 percent in January, and wages increased by 5.4 percent compared to a year ago. A tight labour market is a sign of an overheated economy, putting the bank's credibility at risk.
While the Bank of Canada's decision to maintain its key rate was expected, it's believed the bank will raise the policy rate next month. With an overheated economy, rising inflation, and a tight labour market, a rate hike may be necessary to preserve price stability and financial stability. As a result, people should seriously consider securing fixed-rate mortgages.