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Think mortgage rates will drop? The argument for getting a variable rate now

This post was originally published on August 21, 2023, and was updated on November 1, 2023.

It’s undoubtedly a stressful time to be shopping for a mortgage. Borrowers seeking the lowest rates face scant pickings as both variable- and fixed-rate options have soared since last March; the former driven higher by the Bank of Canada’s aggressive 10-part rate hiking cycle, and the latter due to reactive volatility in the bond market, which broached a 16-year high of 4.5% earlier in October.

Variable mortgage rates have increased by 85% between January 2022 and November 2023, with today’s lowest available options for an insured mortgage in the upper 5 - 6% range. Not surprisingly, this has greatly reduced borrower demand compared to 2020 and 2021. According to Ratehub.ca data, inquiries for five-year variable rates make up only 4% of all rate inquiries thus far in 2023 (compared to 26% in 2022).

Today’s best five-year fixed-rate options, meanwhile, are hovering in the mid 5% range.

Chance of rate cuts increasing in 2024

The Bank of Canada has now opted to hold its trend setting Overnight Lending Rate at 5% in its last two announcements on October 25 and September 6th. This signals that, while the possibility of a rate hike isn't entirely off the table, the central Bank is growing more confident in inflation's progress. According to StatCan, the Consumer Price Index rose by 3.8% in September, down from 4% in August, and below analysts' expectations; a welcome surprise.

More recently, lacklustre GDP numbers - unchanged in August for the second month in a row, and putting Q3 on track for a consecutive flat quarter - suggest the Canadian economy has already entered a technical recession, further cementing the likelihood of rate cuts by the tail end of next year.

"This is yet one more crystal clear sign that the Bank of Canada should be done hiking," writes Benjamin Reitzes, Managing Director, Canadian Rates & Macro Strategist of Fixed Income Stategy at BMO. "The potential for a second consecutive negative quarterly GDP reading will cause recession chatter to ramp up quickly. The soft economic backdrop, which still has downside, will drive inflation down over time...it's just a question of how quickly."

While fixed mortgage rates won’t be directly impacted by a Bank of Canada rate cut, they will be influenced by the market’s reaction; any sentiment that the economy and inflation are softening will lead to a drop in bond yields, and, ultimately, the fixed cost of borrowing.

Fixed mortgage rates can move much more quickly than variable, given the bond market is more fluid than the Bank of Canada’s pre-set announcement schedule and not restricted to quarter-point increments. It’s a possibility that next year’s fixed mortgage rates could be materially lower than their variable rate counterparts, by as much as 50 - 80 basis points. Should this occur, it would provide borrowers who are currently in a variable-rate mortgage the opportunity to switch to a lower fixed mortgage rate, at no penalty.

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Switching your mortgage rate: What borrowers should know

The above scenario would be possible because lenders make it fairly easy to convert an existing variable-rate mortgage into an equivalent or longer fixed term, providing you are sticking with the same lender. Borrowers need only make a phone call to start the process, and are generally not re-stress tested, assuming their financial picture has not materially changed. However, the rate that lenders will offer these clients is typically on par with their posted five-year rates, and won’t reflect the lowest available options on the market.

Another option for variable-rate borrowers is to break their mortgage and refinance to the lowest available five-year fixed rate offered by another lender. This will require them to be re-stress tested, and they’ll also need to pay a mortgage penalty, equivalent to three months of interest. However, if the new mortgage rate is significantly lower than what they’re currently paying, the savings generally outweigh any mortgage penalty they’ll need to pay.

Switching from a fixed mortgage rate to a variable option mid-term, meanwhile, is much more challenging. Lenders don’t offer the ability to convert a fixed mortgage into a variable-rate one, and so the only option would be to break the mortgage and refinance. The penalty to do so tends to be higher for fixed mortgages as well; lenders will either charge three months’ interest or the interest rate differential – the amount of interest lost if your lender were to turn around and lend the funds at today’s rates – whichever is higher.

Of course, a borrower who is renewing their mortgage can switch from a fixed to a variable rate, or vice versa for their next term, without any penalty.

If you think mortgage rates will drop…

This begs the question: If you are shopping for, or renewing, a mortgage rate today, but believe rates are set to drop within the near future, what should your borrowing strategy be?

Option 1: Take out a five-year fixed mortgage rate.

Today’s fixed mortgage rates are slightly lower than their variable counterparts, with today’s lowest 5-year fixed, insured rate at 5.64% – that’s 31 basis points lower than the lowest variable options of 5.95%. 

While switching to a five-year fixed rate from a variable will result in some savings as monthly payments will be lower, it will mean the borrower is locked into today’s elevated rate environment for another five years, and will not be able to change their rate without penalty should fixed mortgage rates decrease in the near future.

Option 2: Get a five-year variable rate with the ability to convert to a fixed rate any time without penalty.

Given the flexibility of a variable-rate mortgage, borrowers who take one out today will still be able to take advantage of lower fixed mortgage rates should they drop within their term. For example, let’s assume that bond yields start to dip within the next year due to sentiment that the Bank of Canada will start cutting rates, pushing the lowest five-year fixed option even lower.

The borrower will have the ability to either convert their existing variable rate with their lender to whatever their posted five-year fixed option is; if that’s still not low enough to be competitive, they can then take the refinancing route, and pay three months’ worth of interest to lock in at the market’s lowest available five-year fixed rate.

Option 3: Get a shorter-term fixed rate now and get a lower rate at renewal time.

Taking out a shorter term two- or three-year fixed mortgage rate today provides some protection from market volatility and the flexibility to make a change to your mortgage in the near future. However, the trade-off is paying a higher rate in the meantime; today’s best two- and three-year terms at 6.44% and 6.04%, respectively. You’d also be unable to switch without penalty during your term, and would need to either break your mortgage or wait until renewal to take advantage of a suddenly-lower rate environment.

The bottom line

It’s impossible to tell with certainty just where mortgage rates will land within the next 12 months, and the above scenarios should be interpreted as potential outcomes, assuming bond markets and the central bank respond as expected to growing recession risks. As well, the rates that may be available to different borrowers will vary, based on the terms of their current mortgage and their specific financial situation. It should be noted that some mortgages have restrictive terms and conditions and not all lenders have all terms available.

If you’re currently on the market for a new mortgage rate, or are coming up for renewal on your existing term, it's always a great idea to work with a mortgage broker, who can help you navigate today’s rate options and determine the best strategy for you over the coming years.

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