Normally, switching from a variable rate to a fixed rate before the end of the loan period means enrolling at a higher rate. Fixed mortgage rates are generally higher than floating rates because people are willing to pay extra for the convenience of knowing that their interest rate will not change.
For months, however, fixed mortgage rates have fallen below floating rates, a rare event that reflects investor concerns about the possibility of a future recession in the United States and Canada.
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For example, currently the lowest five-year fixed rate available nationally for a conventional mortgage is 2.79 percent, according to Robert McLister, founder of the RateSpy.com rate comparison site. The lowest variable rate for a five-year period is 2.89 percent.
This means that holders of variable rates with a mortgage term of five years can lock in a fixed five-year rate inferior compared to their current rate. And what's better than getting a better rate is the tranquility of a fixed mortgage payment?
Not so fast, some mortgage brokers say. Blocking at a lower rate does not necessarily mean savings.
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The mathematics of the "block": three scenarios
To illustrate the concept, Toronto mortgage broker David Larock published the numbers for three future scenarios in a recent one blog post.
Take three homeowners – let's call them Joe, Jane and Rahul – each with an exceptional mortgage balance of $ 400,000 and two and a half years to go on their five-year variable rate mortgage.
Joe's variable rate is pegged at a 0.6 percent discount at the primary rate, a reference rate used by lenders. Based on the current prime rate of 3.95 percent, Joe's rate is now 3.35 percent.
Jane got a slightly better deal, with a variable rate of the first minus 0.85 percent, which means that her current variable rate is 3.1 percent.
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Rahul has the best rate – first minus one percent – and is paying a rate of 2.95 percent.
All three could go to a fixed rate of 2.79 percent today. But should they?
Larock's math shows that blocking may not be a good idea if the economy escalates.
Scenario 1: the economy slows down but then resumes
In the first scenario envisioned by Larock, interest rates initially fell 0.25 percent at the start of 2020 as US growth slows down, which raises concerns about Canada's economic health. Fortunately, however, after the US federal elections, things start to rise again and rates rise by 0.75 percent until 2021.
In this scenario, the lock-in would save all three variable rate holders money in our example. However, if they had to break the mortgage and pay $ 3100 in penalties to access a low five-year fixed rate of 2.79 percent, only Joe would have taken the lead.
Borrowers can convert their variable rate into a fixed rate at their existing lender, which avoids any penalty. However, they would be "at the mercy of the lender", which may not offer them a competitive rate.
Breaking the mortgage means becoming a "free agent" who can look for the best rate available, Larock said. The trick, however, is that you should pay a penalty and, if you are requesting a new loan with a federal-regulated financial institution, qualify yourself for the stress test with the new lender.
Scenario two: the United States plunges into recession
In this scenario, Larock examined what could happen if the US economy had plunged into recession, also dragging the Canadian economy. The Bank of Canada could lower its trend interest rate by 0.75 percentage points, from 1.75% to 1% in several cuts over the course of 2020. However, lenders transmit only a part of such savings to consumers, as they did when the Canadian central bank cut the latest rates in 2015. As a result, variable rates fell by only 0.45 percent overall during the year.
In this scenario, the difference between the postponement and the maintenance of the position would be minimal for all three borrowers two and a half years along the line. However, by switching to a five-year fixed rate, they would still have half the loan term to go to 2.79 percent at a time when more competitive rates may be available, Larock noted.
"Staying now, even at a comparable comparable rate, would probably leave all three borrowers at a variable rate in the long run."
Scenario three: a more serious US recession
If the US economy plunges into a more serious funk in the coming years, the Bank of Canada may be forced to lower its key rate by a full percentage point, with lenders passing 80% of cost savings, writes Larock.
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In this scenario, all three borrowers would be better off sticking to their variable rates. Not only would they save on interest while being tight, but their mortgage would be renewed at a time when interest rates would probably be very low, according to Larock.
"In this situation, it would be better for variable rate borrowers to stay the course. Time would be on their side. "
How to decide whether to change from variable to fixed
In conclusion, if interest rates were to start falling again, holders of existing variable rate mortgages could emerge, according to Larock.
This could happen in the near future. The fact that fixed interest rates are currently lower than floating rates means investors expect short-term interest rates to fall, McLister said.
Historically, variable rates have produced savings over fixed rates in the vast majority of the time, he added.
However, "when it comes to evaluating the direction, what we know for sure is that we know nothing for sure."
There are other ways to assess whether making a change to a fixed rate makes sense. For example, if your financial situation has deteriorated and a fixed rate lock would lower your anxiety levels, the move could be worth it, said McLister.
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On the other hand, if you're simply trying to time the market, "this is a wild goose chase and you probably weren't cut for a variable in the first place," McLister said via e-mail.
However, "if you are stuck in an expensive variable (for example, first – 0.60 percent), you have to assess whether it is worth paying a refinancing at a much lower rate. It often is."
But even then there are exceptions. A borrower with a relatively expensive variable rate that has only had a short period of time until the end of their loan term can get better and stay pending, Larock said.
For example, someone with only six months remaining on the loan's maturity would be able to register at a fixed rate within 120 days of the renewal date and ask the lender to retain it, he added.
On the other hand,
"If I had a variable rate of minus less (0.60 percent) and remained four years at the end of my term, the cost of that non-competitive rate would be amplified by the time remaining on the mortgage. "
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