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 investors and Bay Street economists had expected. It is the fourth rate hike since March as central banks around the world try to curb runaway inflation and slow the pace of consumer price increases. The Bank of Canada’s base rate is now 2.5 percent.
Rapidly rising borrowing costs are already putting pressure on certain segments of the Canadian economy, most notably the housing market, which has seen prices fall and slow in recent months. For those buying real estate, being able to pay off the mortgage is increasingly becoming another barrier to buying real estate.
The impact that interest rate increases have on homeowners and homeowners depends on whether they have a fixed or variable rate mortgage. Those with variable rate mortgages that adjust to the prime rate are more exposed to benchmark rate rises 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 a so-called prime rate, benchmark lenders typically adjust based on movements in the Bank of Canada trend rate overnight.
Lower rates on variable rate mortgages have attracted home buyers in recent years. They made up 37 per cent of new insured mortgages in April, according to the latest data from Statistics Canada and the Bank of Canada, compared to just 5 per cent of mortgages in January 2020.
What is a fixed rate mortgage?
A fixed rate mortgage typically locks in payments for two to five years. Fixed rates are often higher than variable rates, but they offer homeowners peace of mind that their mortgage payments will be consistent for years to come.
What is Canada’s prime rate and how will it affect variable rate mortgages?
The Bank of Canada’s increase was related to the prime rate, which acts as a target for the daily overnight rate, which in turn underpins variable rate mortgages.
The prime rate is the annual interest rate used by major Canadian banks and financial institutions to set interest rates for variable loans and lines of credit, including variable rate mortgages. As prime rates rise, prime rates rise, ultimately increasing the interest rate you pay on your loan. Canada’s prime rate is currently 3.70 percent.
Will mortgage payments go up due to Bank of Canada rate hikes?
When interest rates rise, homeowners pay more in interest. However, not everyone will see their monthly payments increase when rates rise.
Some variable rate mortgages keep payments steady – up to a certain limit, known as the trigger rate – even as the interest rate rises. Instead, these borrowers pay more in interest and less of the principal each month, and their amortization period increases, meaning it will take longer to pay off the mortgage.
But if interest rates continue to rise, interest payments could increase when the trigger rate is exceeded.
What is trigger frequency?
The “trigger rate” is the interest rate level that, when exceeded, causes the mortgage holder’s monthly repayments to change. The trigger rate has been largely ignored for decades since 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 trigger rate—the level at which their regular monthly payments won’t be enough to cover the interest for that period.
The exact starting rate is different for each mortgage holder and depends on the amount of their loan, the amount of their monthly payment, the mortgage interest rate and the repayment period.
Can I convert a variable rate mortgage to a fixed rate?
It is not possible to switch from a fixed to a variable rate without breaking the mortgage agreement (which results in a penalty).
However, it is also possible to go another way. You can lock in a variable rate mortgage to a fixed rate at any time without breaking the mortgage agreement – and if you break a variable rate agreement, the penalty is often much lower.
Should I convert a variable rate mortgage to a fixed rate?
Variable rate mortgages tend to be cheaper than fixed rate mortgages, where the borrower pays the same interest rate for the life of the loan. The rate on the most common fixed term (five years) rose to 4.41 per cent in early June from 2.21 per cent a year earlier, according to Bank of Canada data. Meanwhile, the variable rate mortgage rose to 2.72 percent from 1.63 percent over the same period. Further increases in Bank of Canada interest rates will be reflected in variable 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 of three months’ interest, depending on the lender. You may not be able to lock in the best fixed rate available and your mortgage terms may remain the same. This means that any fixed rate you convert to may only be valid for the remainder of your current term and you will be forced to renegotiate that rate once your mortgage is up for renewal.
That being said, the risk of locking in, especially with a five-year term, is that you could be stuck paying a lot of interest if trends change. Staying with a variable rate means you’ll be riding lower rates once inflation peaks. If Canada goes into recession, interest rates could drop quickly. Switching from a fixed rate mortgage back to a variable one is also costly as it comes with a higher penalty.
The biggest factors to consider when switching are your risk tolerance and the size of your mortgage. In general, lock-in is less attractive when variable rates are significantly lower than fixed rates; however, it is important to consider your ability to keep up with a variable rate mortgage if rates continue to rise. Also, interest rate increases have less of an impact on homeowners with variable-rate mortgages that are small or significantly underpaid.
With files from Erica Alini, Rob Carrick, Mark Rendell and Rachelle Younglai.
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