Higher interest rates and mortgages: What do they help and hinder?

With the Bank of Canada raising its policy interest rate through 2023, experts expect the gap between fixed and variable mortgage rates to shrink. If you’re in the market for a mortgage, here’s some advice on what to consider when deciding which type to opt for.

Variable-rate mortgages have an interest rate that can fluctuate in relation to the Bank of Canada’s overnight rate. Fixed-rate mortgages, which are priced based on bond yields, see borrowers pay the same interest rate throughout the term of their loan.

“The gap really varies [based on] the economic cycle, so it's not surprising that at some points it narrows, and then at some points it widens,” Royal Bank of Canada senior economist Robert Hogue told CTVNews.ca in a telephone interview on Tuesday. “Just a year-and-a-half or two years ago, both the variable and five-year fixed [rates] were about the same, then the gap had widened significantly and now it’s narrowing again.”

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Mark Ostland, director of mobile experience at Meridian Credit Union, says people with variable-rate mortgages will see their monthly interest payments rise as soon the Bank of Canada’s rate hike kicks in. As of May 31, Meridian Credit Union’s rate for a five-year variable mortgage was 2.6 per cent. An increase of 0.5 per cent on a $600,000 mortgage, would see monthly interest payments rise by about $170, Ostland said.

Canada’s central bank raised its overnight rate by 0.5 per cent in mid-April, aimed at cooling inflation with the largest single increase in more than 20 years. According to Statistics Canada, the country’s inflation rate reached 6.8 per cent last month, its highest level in more than 30 years. The Bank of Canada has said its goal is to keep inflation between one and three per cent.

As the gap between fixed and variable mortgage rates closes, experts are hesitant to recommend one over the other.

Variable mortgage rates are lower than fixed mortgage rates at the moment. As of May 31, interest rates for five-year variable mortgages among Canada’s major banks were generally between 2.5 and three per cent, while fixed-rate mortgages secured for five years came with interest rates of 4.5 to five per cent.

Variable-rate mortgages have also historically provided homeowners with cheaper mortgage costs throughout the years, Ostland said, mainly because they are inherently more risky for consumers

“The data shows that, in the long run, variable rates [produce] the lowest rate overall over a long period of time,” he said. “[You’re] going to have some hills and some valleys. Right now, we’re in the hill … but over the last 30 years, we can certainly see the valleys as well.”

Still, Ian Lee, an associate professor at Carleton University’s Sprott School of Business, expects the Bank of Canada to keep raising its policy interest rate to more than three per cent by the end of 2023. As a result, he said it may be worth considering a fixed-rate mortgage, as holders are immune from any rate hikes until their mortgages are up for renewal.

“If anybody thinks that rates are going up, that’s the clue to go fixed,” Lee told CTVNews.ca on Tuesday in a telephone interview. “Because then you lock in [and] it won't go up on you even though the general rates are going up.”

Ultimately, Hogue, Lee and Ostland all say the decision to opt for one type of mortgage over the other comes down to individual risk appetite. Those who would prefer a greater sense of comfort in knowing how much their principal and interest mortgage payments will be each month would be advised to go for a fixed-rate mortgage, said Lee.

Fixed-rate mortgages can provide certainty about monthly payments, Lee said, while people open to taking on some more risk and make increased interest payments over time, variable-rate mortgages remain a solid option.

“If you like to gamble and speculate, well then stay variable,” said Lee. “If you're more fiscally conservative [and] don’t want to be hit with any surprises, then lock in.”

IMPACT ON CANADA’S HOUSING MARKET

With several interest rate increases expected from the Bank of Canada going forward, Hogue said he acknowledges that some borrowers may be concerned about whether they’ll be able to meet their debt obligations. This can be especially challenging given the current high-inflation environment, with the cost of groceries, gas and other items on the rise, Ostland said.

“This is not good for the individual mortgage holder by any means – all this does is increase the interest portion of their [mortgage] payment so they're not paying down the principal,” said Ostland. “That’s a huge disadvantage.”

Nevertheless, Hogue does not expect to see most Canadians defaulting on mortgage payments as rates rise, he said. Part of the reason for this is the stress test that Canadian homebuyers must pass before obtaining a mortgage. In order to qualify for a mortgage, borrowers must prove that they are able to afford interest payments as high as two per cent above their mortgage contract rate, or 5.25 per cent, whichever is higher.

“This is where the stress test becomes really handy because borrowers … have been tested for this type of situation, this very sudden [and] rapid spike in rates,” he said. “So the vast majority of mortgage holders should be able to withstand higher rates.”

Rising interest rates are also expected to continue cooling Canada’s red-hot housing market. Activity within the market showed signs of slowing down in April, with fewer homes sold compared to the month before. The average price of a home in Canada also fell from $796,068 in March to $746,146 in April, according to the Canadian Real Estate Association. These prices are not seasonally adjusted, and represent an aggregate of all residential property types.

As interest rates rise, the expectation is that home prices will decline across Canada in the coming months, Hogue said.

“We think it's going to cool housing demand after having been extremely hot in the summer of 2020,” he said. “That, in turn, will help rebalance markets and lead to some price declines.”

Lower home prices have already led to instances of buyer’s remorse within the market, with some homebuyers expressing concern they may have overpaid for a newly purchased property that is now declining in value. Ultimately, Ostland said, it will result in home prices that are more reflective of the actual value of a property.

“Let's say you went to the store and there's one item on the shelf and 10 of you wanting it, you get caught up in that frenzy of overbidding,” he said. “The cooling down reflects now the true value of a home, not an inflated value based on outside economic factors.”

A decline in house prices is ultimately a good thing, Lee said.

“Young people and immigrants have been phased out of the market in Canada because of this extraordinary, unprecedented and I believe unjustified increase [in home prices] in the last two, three years,” Lee said. “If we want to make housing affordable for [these groups], then we need to accept that the market needs to unwind and reverse some of the tremendous increase that occurred.

“I don’t see any other solution … to high housing prices.”

CONSIDER OFFER CONDITIONS, CONVERTING MORTGAGES

In order to prepare for future increases, Hogue advises Canadians to stay informed on market activity and speak to mortgage specialists for guidance. He also recommends being prudent with spending, and reducing discretionary expenses if necessary to keep up with monthly payments.

“Be very mindful, from a budget perspective, that you may be facing higher interest rates down the road,” Hogue said.

Ostland also recommends that Canadians consider adding conditions to their offers, such as home inspection. With homes likely to receive fewer bids compared to months ago, it’s possible that sellers will be more agreeable to conditions when deciding which offer to accept, he said. It’s also worth looking into the possibility of switching existing variable-rate mortgages for fixed ones, said Ostland.

“[With] a lot of variable lenders, you can convert your variable into a fixed at any point,” he said. “The rates are higher, but it may give you that fixed payment you're looking for, and ultimately that peace of mind.”

Hogue said he forecasts another interest rate hike of 50 basis points in July, followed by two more increases of 25 basis points before the end of 2022. At that point, he said, the bank will likely pause on rate hikes in order to assess the situation and determine the impact of these increases on inflation levels in Canada before making a decision on how to proceed.

With files from Reuters and The Canadian Press.