Should Borrowers Lock In As Interest Rates Rise?

Canadian borrowers have enjoyed cheap loans for years – whether in the form of record-low mortgage rates, or interest charged on lines of credit. That changed in July, however, as the Bank of Canada (BoC) – which sets pricing for such products – mandated that interest rates will start to rise.Canadian borrowers have enjoyed cheap loans for years – whether in the form of record-low mortgage rates, or interest charged on lines of credit. That changed in July, however, as the Bank of Canada (BoC) – which sets pricing for such products – mandated that interest rates will start to rise.

On July 12th, the central bank announced it would be hiking its trend-setting Overnight Lending Rate to 0.75 per cent, a quarter-of-a-per-cent increase. This follows two rate cuts in 2015, which brought it to 0.5 per cent from 1 per cent, where it had been held since September 2010.

As a result, this is the first time in seven years that interest rates are set to rise, meaning the monthly carrying costs of variable-rate loans, including mortgages and LoCs, will become more expensive. For purchasers in Canada’s hottest real estate markets – such as detached, condos and townhouses for sale in Toronto – that can have a profound effect on affordability.

What Is the Overnight Lending Rate?

One of the BoC’s main purposes is to manipulate interest rates to best support the economy. This means it adjusts how cheap or expensive borrowing is depending on economic performance, also referred to as monetary policy. For example, the rate was kept low during the recession and was cut further when oil prices dropped two years ago. This helps encourage consumer spending and borrowing, keeps inflation healthy, and credit liquid during an economy downturn.

On the flipside, the BoC hikes the rate when the economy strengthens, which it has recently – positive economic signals from the U.S. – such as their own interest rate hike – as well as improving Canadian job numbers, oil prices and inflation have paved the way for the BoC to tighten its monetary policy.

The BoC announces the direction for the Overnight Lending Rate in eight pre-planned outlook announcements each year, and mortgage market analysts think there are more to come in 2017 and 2018.

“October 25 is when the Bank of Canada has its next outlook, but I don’t think a rate hike will happen then – instead I think it will be on December 6th,” says Mike Bricknell, mortgage broker at CanWise Financial.

Why Does This Affect My Mortgage?

The Overnight Lending Rate’s influence filters down to borrowers via consumer lenders, which use it to set the pricing of their Prime rates. For example, all five of Canada’s big banks (Scotiabank, CIBC, Bank of Montreal, TD, and RBC) added 0.25 per cent to their Prime rate (from 2.70 to 2.95 per cent) within 24 hours of July’s hike.

Because variable loans and mortgages are structured as an interest rate plus or minus the Prime rate, they fluctuate whenever the Overnight Lending Rate changes.

How Will Variable Rates Be Impacted?

How much more will variable-rate mortgage holders need to pay following the July announcement?

Let’s assume a borrower has purchased a $500,000 home, and made a down payment of 20 per cent ($100,000), leaving a $400,000 mortgage. Let’s also assume the borrower has:

  • A 25-year amortization
  • Today’s best five-year variable mortgage rate (currently 1.94 per cent).

Using a mortgage payment calculator, we find this borrower will have a monthly mortgage payment of $1,682.

However, after building the 0.25 per cent increase into that mortgage rate, it becomes 2.19 per cent, and the borrower’s monthly costs increase to $1,731. That’s a difference of $49 per month, and $588 over the course of a year.

Is It Time to Lock In?

In a rising rate environment, it’s common for borrowers to wonder if a fixed mortgage rate is the way to go. While typically more expensive than variable, a fixed-rate mortgage rate remains the same throughout the whole five-year term, and is only renegotiated come renewal time.

For many borrowers, this offers financial peace of mind, helps maintain a regular budget, and offers a multi-year reprieve from whatever is happening in the market. In fact, it’s possible to convert an existing variable-rate mortgage into a fixed one, at the lender’s fixed posted rate.

However, historically, variable rates have always been cheaper than fixed; even when interest rates rise, the spread between variable and fixed mortgage rates is wide enough that variable borrowers pay less on their mortgages overall. Consider the lowest five-year fixed mortgage rate, which is currently 2.64 per cent. At that rate, our borrowers’ monthly carrying costs rise to $1,820 – still $89 higher than the hiked variable rate.

James Laird, President of CanWise Financial, says it’s important for borrowers to closely consider their personal appetite for risk when deciding if variable is still the way to go.“It is a very logical time to consider whether you should lock in, and weigh the various scenarios,” he says. “Scenario A is a borrower saying, ‘I understand there is upward pressure on rates, and there will be exposure to more interest rate pressure over the next five years, and my strategy is to stick with variable because historically it has been cheaper.

’Scenario B is if, during this self-analysis, they say, ‘My appetite for risk has gone down since I got the variable rate, and I now see the value of locking in my rate payments, even though they’ll automatically be higher than what I currently have, and will hedge risk and will let me budget perfectly.

’”Another consideration is that fixed mortgage rates, while not directly impacted by the Bank of Canada, are also prone to rise when the economy is performing well. That’s because fixed-rate loan pricing is impacted by bond yields – the guaranteed profit on popular fixed-income investments. This yield – also referred to as the “coupon” – indicates how popular bonds are based on their perceived risk. When bond yields rise, it reflects a stronger economy, and as a result, lower investment risk. However, this prompts existing bond holders to sell off their bonds, because they’ve now become devalued compared to the newer, higher-yield investments. To make up the gap, lenders price their fixed-rate mortgages higher.

“We are directly affected by Canadian bond yields, which have been increasing for some time now,” explains Bricknell. “As bond yields rise, the offset Is that mortgage won’t be far behind.”

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