Almost every mortgage shopper has the same question at some point, especially when rates are surging or diving:
“Should I Lock in My Mortgage Rate?”
Answer this correctly and you’ll save thousands in interest. Pick the wrong rate type, and it could cost you just as much.
Seemingly everyone’s got an opinion on fixed or variable rates. But unless they’ve taken the time to understand your personal finances, your plans and your comfort level with rate volatility, their 2 cents is worth just about….2 cents.
What follows is a checklist of decision factors that everyone needs to weigh when deciding between a fixed and variable mortgage rate (or a long or short term).
Reasons to lock in
☐ You’re Worried It’s Different This Time
- Prominent research suggests that fixed rates underperform variable rates, but that conclusion depends heavily on the rate assumptions used.
- Historical backtesting confirms that when the best fixed rates are close to the best variable rates (e.g., about 0.25% apart) and variable discounts are smaller than normal, 5-year fixed rates have outperformed more than 3 times out of 10.
- Some Perspective: Research is always a rearview mirror. It may be a good indicator of long-term trends, but doesn’t tell us what’s coming in the next five years, or factor in changing inflation and bond market risks. (Threats of higher inflation and high demand for borrowing can both drive rates higher, and vice versa.)
☐ You Can’t Afford an Interest Spike
- A one-point hike in rates will cost you roughly $80 more interest each month for every $100,000 of mortgage.
- If you’ve got a variable mortgage with fixed payments, you won’t experience payment shock during the term of your mortgage.
- There are rare exceptions, namely when rates jump so much that you’re not covering your interest. Most lenders will then raise your payments.
- By contrast, if you have a payment that floats with prime rate (a.k.a., an adjustable rate mortgage or “ARM”), then a hypothetical 2-point rate hike would jack up those payments by $300 a month on a $300,000 mortgage.
- In the three rate cycles prior to the financial crisis, prime rose an average of 3.16 percentage points from its trough to its peak.
- Spy Tip: If you want to be ultra-conservative, use this mortgage stress test calculator and check what your payments would look like with a 2.00–point rate hike. Incidentally, regulators require all prime mortgage borrowers to prove they can afford a rate that’s two points higher than their actual, or typical, rates.
☐ The Break-Even Rate is Low
- Imagine you can get a variable-rate mortgage at 2.00% today. If we make some basic assumptions (like rate hikes occurring in the middle of your five-year term), here’s roughly how high rates must rise for that variable mortgage to cost you more interest than a 5-year fixed:
- 0.50%-point, assuming a 2.19% five-year fixed mortgage
- 0.75%-point, assuming a 2.29% five-year fixed mortgage
- 1.00%-point, assuming a 2.39% five-year fixed mortgage
- As these numbers illustrate, the lower the 5-year fixed rate (relative to variable rates), the lower your breakeven rate—and the better your chances in a long-term fixed if rates increase.
- Spy Tip: When the difference between a long-term fixed rate and a variable rate is less than 1/2 a percentage point, you’re paying very little (historically) for the insurance of a fixed rate. Just remember that the difference is sometimes that small for a reason. It’s sometimes because the market expects lower rates ahead.
☐ You Think You Can Time Rates
- Let’s be honest, you can’t. And if you can, you should be running a hedge fund making an 8-figure salary.
- Not only will the bond market fake you out like an Allen Iverson crossover, but even if you could precisely predict rates in the next year, it would do you no good, research shows.
- And don’t plan to convert your variable to a good fixed rate when you see prime rate increase. Bond yields—which steer fixed mortgage rates—almost always rise several weeks before the Bank of Canada hikes rates. By the time you lock in, yields will likely have lifted 5-year fixed rates by at least 30 to 60 basis points.
- Be aware: Lenders often shrink their discounts when surging demand for fixed rates outpaces their supply of funding.
- Spy Tip: If you’re prone to lock in your variable-rate mortgage, don’t gamble. Get the best fixed rate you can from the get-go.
☐ Rates are Near Zero
- If Canada’s overnight rate approaches zero, it gets harder for banks to make money, on variable rates and in general. In that sort of environment, banks may choose to keep prime rate higher than the Bank of Canada’s overnight rate warrants, and/or they may reduce their discounts from prime rate.
- In such a case, even if the Bank of Canada cuts rates to zero, consumers may not see a matching reduction on their variable rate mortgage. That can diminish the benefit of a variable rate.
☐ You Can’t Re-qualify
- You don’t want to worry about re-applying for a mortgage if:
- There’s risk to your income (potential job loss, planned leave, etc.)
- You have a high debt-to-income ratio, which could prevent you from passing the federal mortgage stress test.
- In these cases, short-term mortgages (like a 1-, 2- or 3-year fixed) are unsuitable, as are adjustable-rate mortgages with the risk of higher payments.
- If your financial situation is less than solid, then—assuming a mortgage makes sense at all—lock into the best 5-year fixed you can find.
- Spy Tip: You’re also more at risk if you’ve got less than 20% equity. In such cases, if you had to lower your payments or consolidate debt, you wouldn’t be able to refinance cost-effectively. Reasonably-priced refinances are only available if your loan-to-value is 80% or less.
☐ You Might Break Your Mortgage
- The average borrower in a 5-year term renegotiates and/or breaks their mortgage in about 3.7 years.
- The fee for paying off a 5-year fixed mortgage early can easily cost you thousands, especially if your lender charges a bank-style “interest rate differential” (IRD) penalty.
- Spy Tip: The more rates fall, the bigger IRD penalties can get.
- With a variable mortgage, you generally pay just a 3-month interest penalty (the exceptions are low-frills mortgages, which have ugly penalties of up to 3% of your principal).
- Even if rates go sideways, IRD penalties can be thousands higher than variable penalties, especially if your lender is a major bank or you have a “low-frills” mortgage.
- Canada’s Big 6 banks have IRD penalties that are often more than double those of mortgage finance companies. See for yourself by plugging the exact same assumptions into a mortgage penalty calculator. Here’s an example of someone who got a mortgage three years ago and wants to break it two years before maturity:
Sample penalty from Canada’s biggest bank:
Sample penalty from Canada’s biggest non-bank lender:
- These two scenarios use the exact same assumptions. Yet the major bank’s penalty is more than twice as large as the non-bank’s.
- Spy Tip: If you want the flexibility to refinance at another lender (at best rates) or break your mortgage before maturity, think hard before locking into a long-term fixed rate—especially at a Big 6 bank.
☐ You Might Move
- Most fixed rates are portable if you change homes and want to take your mortgage with you to avoid a breakage penalty. Many fixed mortgages also let you increase your borrowing before maturity—at the lender’s then-current rates—without a penalty (a.k.a., “blend and increase”).
- Spy Tip: Many lenders do not have penalty-free blend and increase options. Many say they do but they sneak the penalty into your new “blended” interest rate. Be careful to choose the right lender if you might need to increase your fixed mortgage later.
- Most variable rates are also portable. But many are not increasable. Without a blend and increase feature, you’d have to break the mortgage and pay a penalty if you wanted to increase your loan. Those who choose a variable-rate mortgage and later buy a more expensive home, often find this out the hard way.
Reasons not to lock in
☐ You’ve Got an Amazing Rate
- If you can get a variable or short-term fixed rate that’s 75+ basis points below going 5-year fixed rates, interest rates could jump over 1.00 percentage point and you’d still pay about the same interest cost as someone in a 5-year fixed.
- Note: This rule of thumb doesn’t work if rates surge early in your mortgage term (e.g., in the first 12 months).
☐ You’re a Disinflationist
- Rates will likely never gain much altitude so long as inflation stays near or below 2%. That’s its average over the last 25 years.
- Mega-trends like aging consumers, automation, offshoring, outsourcing, internet retailing, over-leveraged consumers and cheaper energy have conspired to suppress inflation.
- If you’re betting on those trends persisting, and there’s a fair chance they might, then the threat of soaring inflation and monster rate hikes is less of a concern.
- Spy Tip: When the Bank of Canada starts a new rate cut cycle, or the yield curve inverts (i.e., 10-year government bond yields are lower than the overnight rate), and/or unemployment rises over 1/2 percentage point from its lows, history has shown that interest rates fall for multiple years thereafter, the majority of the time.
☐ You’re Financially Secure
- Strong borrowers can withstand sizable rate hikes.
- What’s a sizable rate hike? Over 200 bps is a good rule of thumb.
- What’s a strong borrower? Someone who has:
- Enough savings to pay 6 months of their mortgage
- A stable job
- A reasonable consumer debt load, and
- A mortgage payment, property taxes, utilities and condo fees that total less than 1/3 of their gross monthly income
☐ Your Mortgage and/or Amortization are Small
- Risk is relative, and it depends partly on the size of your mortgage.
- For example, paying a 2-point higher mortgage rate will cost you about $450 more interest each month on a standard $300,000 mortgage, but just $150 more on a $100,000 mortgage.
- A small mortgage relative to your home’s value also affords you more options if you need to refinance to improve your cash flow.
- Spy Tip: It’s easier to get approved if your loan-to-value (LTV) is 65% or less. There are many more lenders willing to lend when a borrower has 35%+ equity. These low-LTV mortgages often have cheaper rates too, unless your credit is shabby.
- Higher rates hurt less when you have a short amortization.
- Here’s a simple example: Over a five-year term, a 1%-point higher rate increases your interest cost almost 80% more on a 25-year amortization than a 5-year amortization.
☐ You’re a Risk-Tolerant Rate-hike Skeptic
- We’ve spoken with a lot of economists over the years. We like to ask one question in particular: “What mortgage term would you choose if you had to pick between a 5-year fixed and a variable?” The most popular answer: “a variable rate.” Why? Because they know two things:
- It takes less monetary tightening to slow today’s over-leveraged consumers.
- Whereas it might have taken a 3-point rate hike to control inflation in the past, today it could take half that. Thus, the upside risk in variable rates is theoretically more capped today.
- GDP has been in a long-term downtrend with no sign that we’ll return to the glory days of consistent 4%+ growth.
- Sustained 4% growth, even if only for 3-4 quarters, would almost certainly boost interest rates materially. But it’s questionable how long it would last.
- It takes less monetary tightening to slow today’s over-leveraged consumers.
☐ If Rates Have Already Risen
- History is clear on one thing. If rates are already up 150-200+ basis points, your odds of saving more in a variable soar.
- Spy Tip: If rates have increased 150+ basis points from the lows of the cycle, financially stable borrowers should start looking at shorter terms, like a 2-year fixed rate instead of a 5-year fixed. Once rates rise over 200 basis points from cycle lows, all but the most risk-averse borrowers should consider short or variable-rate terms.
☐ Your Lender is Noncompetitive
- When you lock in your variable rate to a fixed rate, the fixed rate you get is called a “conversion rate.”
- Some lenders quote conversion rates that are more than 1/4 to 1/2%-point above their best discounted rates. Scandalous!
- If your lender is a rate pirate on conversions, that’s just one more reason to ride out a variable rate.
☐ Because Economists Predict Higher Rates
- Your grandma could probably predict long-term rates as well as most economists. Research shows that economists have an optimism bias and can’t foresee recessions. Their predictions give you utterly no edge.
- If you’re prone to rely on rate predictions that are wrong half the time, save yourself the guesswork and consider a hybrid mortgage (one that’s half fixed and half variable).
Boiling it down
Choosing the optimal mortgage term is rarely a single-factor decision. People lock in—or don’t—for multiple reasons. What you need to do is weigh the factors above and ask your gut whether the risk of a variable is worth the reward of a variable. Then make the call on your own….because no one knows your mindset and finances better than you.