Lock-In or Ride It Out: The Variable Rate Mortgage Dilemma

I’ve always been transparent about my mortgage strategy. I prefer to select a deeply discounted variable rate (prime minus 0.80% or better), but if that’s not available then I’m happy to take a 1 or 2 year fixed rate mortgage and wait for those discounted variables to return.

We’ve been in our house for 11 years. Our first mortgage term was a 5-year variable rate at prime minus 0.80%. When that term came up for renewal the best variable rate discount was prime minus 0.25%. Not good enough, so I opted for a 2-year fixed rate of 2.19%. That term came up for renewal in 2018 and sure enough the variable rate discount had come back in a big way. I ended up with a 5-year variable rate at prime minus 1.15%.

Of course, variable rate holders were treated to an unexpected series of rate cuts when the Bank of Canada slashed its trendsetting overnight rate by 0.75% at the beginning of 2020. That dropped the interest rate on my mortgage to an absurdly low 1.45%.

Fast forward to 2022 and the Bank of Canada is widely expected to increase interest rates this year, starting as early as March. I’m not in the rate prediction game, but we’d be foolish not to at least expect the 0.75% emergency rate cuts from 2020 to be restored.

Meanwhile, my mortgage term doesn’t come up for renewal until September 2023. If I believe the headlines from economists and other forecasters, we may be in line for six to eight rate hikes before then. What’s a variable rate mortgage holder to do?

The Variable Rate Advantage

Variable rates borrowers typically save money versus five-year fixed rate borrowers. That was true from 1950 through to 2000, according to a famous 2001 study by finance professor Moshe Milevsky. He updated the study again in 2008, with a similar conclusion that “the probability of coming out ahead with a variable rate had increased to just over 90%.”

Fixed rate mortgage holders pay a premium for certainty in their payments. The less talked about disadvantage to a 5-year fixed rate term is that they can be terribly expensive to break if you sell your home or need to refinance in the middle of the term.

Variable rate mortgage holders save money because of the built-in discount. On a deeply discounted variable rate mortgage, rates would need to rise at least three or four times before it climbed above a fixed rate alternative. Furthermore, variable rate holders have the advantage of only being charged a three-month interest penalty for breaking their mortgage early.

The Variable Rate Dilemma

Now to the dilemma for variable rate mortgage holders like me. Nobody likes to lose money. Faced with the near certainty of rising rates in the coming months, it’s a lot like knowing the stock market is going to fall and trying to decide if you should sell or stay the course (Ed. note: We can’t actually predict the direction of the market so just stay the course).

My gut tells me to take the same approach as I would with my investments. Stay the course. But I wanted to get an outside opinion so I reached out to mortgage analyst Rob McLister and asked him:

“With everyone screaming “lock-in” is there any merit to doing so with just 18 months left on my mortgage term? And what exactly does locking in entail for a variable rate holder?

He said that variable-rate borrowers have four main options:

1. Do nothing and ride out rising rates
   • This may be the best play for someone with financial stability, a good variable discount (prime -1% or better), a modest mortgage relative to income and/or a short (e.g., <10 year) remaining amortization (Ed. note: We check all of these boxes).
   • It’s particularly appropriate for those who may need to increase or break their mortgage before their existing term is up. Variable-rate prepayment penalties are often significantly less than fixed-rate penalties.
2. Cancel their existing contract, pay (usually) a 3-month interest penalty, and get a new variable rate
   • This can work for financially stable borrowers with a reasonable debt load who want to float their mortgage, but have an inadequate discount on their existing variable. 
   • The lowest nationally-available variable rate for qualified borrowers is now 1.39%. That’s prime -1.06%. This rate applies to all mortgage types, including refinances. Purchase, transfer or insured rates are 0.10% to 0.30% cheaper.
3. Convert their variable to a fixed rate
   • It would take at least seven rate hikes in the next 18 to 24 months for the lowest widely-available fixed rate to beat the best 5-year variable, based on interest cost alone. The market is currently pricing in six hikes this year (source: Refinitive Eikon OIS rates).
   • If a 2% increase would stress your budget too much, and you’ve got an adjustable-rate mortgage (where the payments floats with prime), you may want to grab 3-, 4- or 5-year fixed while you can still lock-in one under 3%. 
   • If you do lock-in, minimize your penalty risk. Chose a “fair penalty” lender and/or make sure you won’t need to increase or break your mortgage before the term is up. Meaning, don’t take a 5-year fixed if you may need to refinance or sell (and not re-buy) next year.
4. Break their mortgage (pay usually a 3-month interest penalty) and get a new fixed rate.
   • Occasionally a lender’s fixed rates will be too high relative to the competition. In that case it’s often more economical to pay the three-month interest penalty and move to the lender with the best fixed-rate on the market.

There are naturally exceptions to the above, especially for less qualified borrowers, so personalized advice can help. 

You can lock in simply by contacting your lender and completing simple paperwork, online or in person.

One last thing: Too many people make binary decisions on their rate. You don’t need to pick between fixed or variable, you can choose both. Hybrid mortgages let you allocate half of your balance to a fixed rate and half to a variable rate, or any other combination. That provides valuable rate diversification, given no one can predict the future, and guarantees you won’t be more than half wrong. You can find hybrids at 2.17% or less from lenders like HSBC or Scotia eHOME.

Final Thoughts

Thanks to Rob McLister for providing these options for variable rate mortgage holders like me who may be nervous about interest rates rising in the near future. For me, I think about the money I’ve saved for the past two years when rates were slashed by 0.75%. I accept (and expect) that those rate cuts will be restored very soon. What happens after that is anyone’s guess. 

In the meantime I will hold onto our existing variable rate mortgage at prime minus 1.15%. I know that our mortgage payment won’t change when rates do rise – the payments are fixed – but less of the payment will go towards principal and more will go towards interest. That’s okay. I’ve already saved a bunch of money over the life of this 5-year term.

When this term comes up for renewal in September 2023, I’ll do what I’ve always done. Look for another heavily discounted variable rate mortgage or, if that’s not available, take a short-term (1 or 2 year) fixed rate term.