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Mortgages and Inflation: How Do They Affect Each Other?

Jordan Lavin

It suddenly seems like everything is getting more expensive. Gas, groceries, and even Netflix have gone up recently and it doesn’t look like things are going to get better anytime soon.

Inflation is also sure to affect your mortgage. Keep reading to find out how inflation affects your mortgage and what you can do to minimize the impact.

What is the relationship between inflation and mortgage rates?

Some inflation is a natural sign of a healthy economy. But when inflation rises too fast, it can get out of hand. As everyone races to raise prices to try to keep up, the value of the dollar can drop sharply. Left unchecked, it can cause a recession. In extreme cases, currencies have become completely worthless – to the point where it’s cheaper to literally burn cash than buy firewood.

To keep that from happening, the Bank of Canada (BoC) has a mandate to keep inflation at a target rate of 2% per year. It does this by setting a target for the overnight rate, which is the cost for banks to borrow money from each other (literally) over one night. When the overnight rate goes up, the banks raise their interest rates to cover their costs. When interest rates go up, people are less likely to borrow money, so they rein in their spending and become more likely to save. This, in turn, puts downward pressure on prices and slows the rate of inflation.

Icon depicting rising prices.

Prices rise

BoC raises overnight rate

Banks raise interest rates

People watch their pennies

Companies lower prices to compete

Variable mortgage rates are directly affected by interest rate hikes because they’re expressed in relationship to the bank’s prime rate. For example, the best variable mortgage rates are currently Prime – 1.3%. Because the prime rate is currently 3.20%, you would pay an actual mortgage rate of 1.90%. If the BoC raises the overnight rate by 25 points (0.25%), and the bank raises its prime rate by the same amount, your mortgage rate would go up to 2.15%.

 

Prime Rate

 

Mortgage rate discount

 

Actual mortgage rate

Original

3.20%

-

1.30%

=

1.90%

After 25 point rate increase

3.45%

-

1.30%

=

2.15%

Fixed mortgage rates aren’t directly affected by interest rate hikes. Existing fixed-rate mortgages aren’t affected when rates go up or down. Rates for new fixed mortgages are still likely to go up, but they’re not tied to the bank’s prime rate. Instead, fixed mortgage rates closely follow bond yields which are pushed higher as a knock-on effect of rising rates.

Variable mortgage rates

BoC raises overnight rate

Banks raise interest rates

 

Mortgage rates rise immediately

Fixed mortgage rates

BoC raises overnight rate

Banks raise interest rates

Bond yields go up

Rates for new mortgages rise slowly


What does inflation and rising rates mean for my mortgage?

If you have a variable-rate mortgage, you’ve probably already noticed that your monthly payment has gone up to cover the higher cost of borrowing. As interest rates continue to go up, your mortgage payment will continue to rise each month to match your new rate. 

While a higher mortgage payment can sting, you’re likely still paying less than if you had chosen a fixed-rate mortgage. If interest rates continue to rise, however, that could quickly change.

If you have a fixed-rate mortgage, nothing will change for you until your mortgage is up for renewal. However, you’re likely to pay more than you are now when the time comes. The best 5-year fixed mortgage rates in Canada have recently shot up to 3.49%, the highest since 2011. If your current rate and payment were 2.49% and $2,500, respectively, renewing today would bump up your monthly payment to $2,733.

Should I switch from a variable to fixed-rate mortgage?

If you have a variable-rate mortgage, you may be wondering if switching to a fixed rate can help you get ahead of rising costs. 

The primary benefit of switching to a fixed-rate mortgage will be the stability it brings. Your mortgage rate and payment would be guaranteed not to change for the entire term of the mortgage. In an era of rising inflation, it could be very comforting to know you don’t have to worry about your mortgage payment going up any time soon.

Locking in a fixed mortgage rate may not save you money, however. Because the gap between fixed and variable mortgage rates is roughly 1.5%, your rate would have to go up significantly within the next 5 years to make the change worth it. In fact, this table shows how if your mortgage rate were to go up by 0.75% per year for 5 years, it would still not be worth the hassle of signing a fixed mortgage.

Year

1

2

3

4

5

Average

Fixed Rate

3.49%

3.49%

3.49%

3.49%

3.49%

3.49%

Average Variable Rate

2.00%

2.75%

3.50%

4.25%

5.00%

3.50%

There have only been a few times in history that fixed-rate mortgage holders have come out ahead of variable-rate mortgage holders. This could be one of those rare times, but I would still make a consistent payment my primary motivation for switching from variable to fixed.

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What else can I do to navigate rising mortgage rates?

Even though mortgage rates are rising, they’re still near all-time lows. Prior to the Great Recession of 2008-09, rates bobbed around the 5%-6% range. In the 1970s and 1980s, mortgage rates of 10%-12% were typical. Since it’s not inconceivable that mortgage rates could return to those levels, you may want to start making changes now to prepare.

Here are a few things you might want to do to prepare for rising mortgage rates:

  • Start making extra mortgage payments now: For the last few decades, mortgage rates have been so low that it hasn’t made much sense to pay your mortgage any faster than you have to. As rates rise, choosing to make additional payments reduces the balance you owe on your mortgage. In turn, you’ll save money on interest and pay off your mortgage faster. Making extra payments now can also help you adjust to a future of higher mortgage payments. Use a mortgage payment calculator to estimate how much your payment might be at a higher rate. You can always stop those extra payments if your minimum payment goes up. 
  • Renew your fixed-rate mortgage early: If you have a fixed-rate mortgage, you may want to explore the possibility of renewing early. If you stay with the same lender, they might permit you to sign a new 5-year term without penalty. While you’re likely to pay a higher mortgage rate in the near-term, this strategy could help you put off the shock of a large increase at renewal if rates continue to rise.
  • Consider switching to a variable mortgage rate at renewal: While it may seem counterintuitive, you might be able to save money by switching to a variable-rate mortgage at renewal rather than signing on for another 5-year fixed term. Variable mortgage rates are significantly lower than fixed rates. And most variable-rate mortgages can be converted to a fixed rate at any time, so the risk is relatively low.
  • Call your mortgage broker or lender: If you’re concerned that rising inflation and mortgage rates will make it difficult for you to keep up with your mortgage payments, proactively reach out to your mortgage broker or lender to discuss your options. They will be willing to work with you to find solutions to keep your payments affordable. For example, you may be able to lower your payments by changing your payment frequency, extending your amortization, or switching to a new lender. If inflation gets out of control like it did during the inflation crisis of the early 1980s, lenders are likely to come up with creative solutions to help you navigate the situation without losing your home. Be sure to ask questions and remember you don’t necessarily have to accept the first offer.
  • Do nothing: As long as rates continue to rise, your mortgage will become more expensive no matter what you do. Trying to time the market is nearly impossible. You might simply choose to carry on as you already are and let the current carry you rather than waste energy trying to swim against it.

The bottom line

We’ve been fortunate to avoid rising inflation and mortgage rates for decades, but our free ride looks to be coming to an end. Rather than trying to time the market, your best course of action may be to start making additional mortgage payments to get used to a higher price and reduce interest payments for your future self. 

If things get really out of hand, ask for the help you need. Get in touch with your lender or mortgage broker for solutions that fit your unique needs.

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