Fixed vs Variable Rate Debate
I have received a lot of questions regarding the difference between fixed and variable rates. What are they based on? Do they both move at the same time? Why is it harder to qualify for a variable? All great questions, and all questions that you need to be clear on before signing into a mortgage contract. Fixed mortgage rates follow the pattern of Canada Bond Yields, plus a spread, where bond yields are driven by economic factors such as unemployment, export and inflation. Variable mortgage rates are driven by the same economic factors, except variable rates fluctuate with movements in the prime lending rate, the rate at which banks lend to their most credit-worthy customers. Variable mortgage rates are typically stated as prime plus/minus a percentage discount/premium. For example, a variable rate could be quoted as prime - 0.8%. So, when the prime rate is, say, 5%, you will pay 4.2% (5%-0.8%) interest.The Bank of Canada adjusts the prime rate depending on the state of the economy, as determined by the economic factors introduced above. Together, combinations of unemployment, export, and manufacturing values shape the inflation rate. Generally speaking, when inflation is high, the Bank of Canada will increase the prime rate to make the act of borrowing money more expensive. Conversely, when inflation is low, the Bank of Canada will decrease the prime rate to stimulate the economy and improve the attractiveness of borrowing.In terms of the discount/premium on the prime rate applied to variable rates, mortgage lenders set this based on their desired market share, competition, marketing strategy and general credit market conditions. These are the same factors that drive the spread between lenders' fixed mortgage rates and bond yields.Qualifying for fixed and variable rates has changed over the last couple of years. Before I break down the differences in qualifying, let's talk about the Benchmark rate in Canada. The benchmark rate is a rate that lenders are required to use to qualify mortgage borrowers in Canada who want a variable rate mortgage or a fixed mortgage term of less than 5 years.The purpose of using a qualifying benchmark rate is to ensure that those who qualify for a mortgage in Canada can qualify with breathing room. In the event of a downturn in the economy or increase in rates down the road, this prevents Canadians from becoming orphaned homeowners without a lender willing to assist them. We are in an era of all-time low interest rates, so the sad reality is they have nowhere to go but up. Purchasing a home at a rate of 2.99% looks amazing today, but the payments can be substantially higher when you renew in five years at 5.5%. This is something referred to as 'Payment Shock'. (To be discussed in an upcoming newsletter... hint hint, watch for it!) Our Minister of Finance, Jim Flaherty, deemed it necessary that all fixed 1, 2, 3, and 4 year, and all variable mortgages qualify at the benchmark rate. The benchmark rate in Canada is currently set at 5.34%. This translates to buyers affording less because of inflated interest rates that act as a safety net.The only way to avoid qualifying at the Benchmark rate is to opt into 5 to 10 year fixed terms. These terms allow you to qualify at the contract rate (the rate being offered by your Mortgage Advisor). The difference in the contract rate and the benchmark rate can be very significant. Here is an example:Suzie and Charlie want to purchase their first home. After speaking with their Mortgage Advisor, they are given two options:1. $400 000 with the 5 year fixed at 3.59%, or2. $335 000 with the 5 year Variable at Prime-0.4% (2.6%)Even though option 2 has a lower interest rate, it needs to be qualified using the Benchmark rate (5.34%), so their purchase becomes noticeably less.To sum this up, fixed rates and variable rates are two completely different products and are actually very independent of one another. I understand this can be a very confusing topic, so don't hesitate to contact me with your questions!