Should You Go With A Fixed Or Variable Rate Mortgage In 2022?
Introduction
Even though overnight rates haven’t come up yet, longer-term bond yields have already risen because of interest rate expectations, and so fixed mortgage rates have already risen around 60 basis points from their lows at the end of 2020. At the same time, variable rates have remained more or less the same since the end of 2020 and have actually been dipping even more recently, so the gap between fixed and variable rates has gone from a difference of 40 basis points at the start of 2021 to around 120 basis points now at the end of 2021.
Right now, 5 year variable mortgage rates are around 1.4% and the 5 year fixed rates are around 2.6%, so the fixed rate interest expense is almost double what you’d be paying on variable. Because of this, the market share of variable mortgages is at all-time highs, currently sitting at a massive 54% as of July 2021, a lot less than in early 2020, when the percentage was only 10%.
I’ve already done a video that compares fixed and variable rates and gives an intro on the differences between the two, so if you want to get a good intro, watch that first. We know that fixed rates remain the same throughout the whole term, but variable rates will change over time. In this video, I’m going to compare what’s actually more likely to be better: locking in fixed rates or going with variable rates based on recent updates in interest rate expectations.
Rate Hike Expectations
We know that variable rates at 1.4% are cheaper now, and there is a chance that they could go even higher than 2.6% sometime in the next 5 years. But even when that happens, that doesn’t necessarily mean fixed rates are the better choice.
A better way to look at it is to look at your total average rate over your entire term, say 5 years, to see if that average rate over 5 years will be higher than a fixed rate at 2.6%. To get this, let’s take a look at what the market is expecting. Consensus tells us rates are expected to go up in mid-2022 by 25 basis points in Q3, Q4 and another 25 basis points in Q1 of 2023, totaling 75 basis points, which means overnight rates might go from the current 0.25% to 1% by Q1 of 2023. Beyond that, things get more uncertain depending on how inflation, COVID, and the new omicron variant, as well as the overall recovery pan out.
What's Better Based On Neutral Rate Range?
The Bank of Canada comes up with a neutral rate every year, which shows what the expected overnight rates should be if the economy goes back to normal and inflation is on target. In their latest report, they estimate the current neutral overnight rate to be in the range of 1.75% to 2.75%.
In other words, if overnight rates end up being at the lower rate of 1.75% at the end of the 5 year terms, we’re going to see a similar 150 basis point rate hike on variable rates. Let’s keep things simple and assume a more linear increase starting in 2023. When we do this, we’ll find the average variable rate over the 5 year term would be 2.3% if we assume a 150 basis point rate hike. If you compared this with the current 5-year fixed rate at 2.6%, variable rates are still better.
But what if rates end up at the upper bound of the Bank of Canada’s neutral rates? If that happens, variable rates will go up 250 basis points instead, and so we’d be looking at an average 5 year variable rate closer to 2.7%. In other words, choosing fixed rates would be better.
Remember, this is on the more extreme basis, so perhaps we can try to see what will happen in the most average case, at the midpoint of the neutral rate. The midpoint is a hike of 200 basis points. If this happens, the average variable rate will be 2.5%. This would be better than choosing a fixed rate at 2.6%.
What's Better Based On History?
Of course, this is just based on what the Bank of Canada projects, so if you don’t buy their projections, then we can try to look at things another way by looking at history.
In the 80’s, we suffered through a prolonged recession and a highly concerning stagflation scenario, with GDP down, unemployment up, and inflation skyrocketing. It didn’t end until the early 90’s when the Bank of Canada decided to tackle inflation head-on, and so things finally started to calm back down.
Things finally started to stabilise by the end of 1996, and that’s when overnight rates dropped back to the more normal levels that we’re used to seeing at around 3%. Then, over the next three years, overnight rates rose 275 basis points before peaking in Y2K, when rates had to be brought back down due to the dot-com bubble.
Let’s look at the next cycle when things started recovering in 2002 and then eventually peaked in mid 2007. Over those five and a half years, overnight rates went up a total of 250 basis points before the financial crisis hit.
The financial crisis caused overnight rates to drop back to record lows of 0.25% in the spring of 2009. The market was still fragile and so rates tried to go up by 75 basis points for a few years, but then had to come back down in mid 2015. So, from 2009 to 2018, a period of over 9 years, rates only went up by 150 basis points in total.
If you average those out, the average rate hike of those cycles was around 181 basis points, which is lower than the Bank of Canada’s mid-point neutral rate. And if that happens, we know choosing variable rates will be better off compared to fixed rates.
Other Things To Consider
Now, besides choosing the lowest expected rates, another thing you should consider are additional risks. On one hand, variable rates do have that added risk that rates can go up a lot more than expected. In that case, having a cap from fixed rates is definitely safer.
At the same time, you also have to understand that fixed rates have a higher penalty risk, and this is very important if you think you might break a mortgage before the term ends. The penalties for variable rate mortgages are generally calculated based on 3 months of interest. But breaking fixed mortgages might mean a much higher penalty because they are subject to interest rate differential calculations.
Let’s take a look at what this means. Right now, the break even price between 5-year fixed and 5-year variable rates is a rate hike of around 225 basis points. So, if actual rates go up by less than 225 basis points, then variable rates are better. If actual rates go up more than 225 basis points, then fixed rates are better.
But what gets priced in can change at any time. So, if market sentiment shifts and 5-year fixed rates fall by 50 basis points, you may face higher penalties if you default on a fixed-rate mortgage. Let’s say you have 4.5 years left and you are locked in at 2.6% for a mortgage amount of $800,000. If current posted rates change to 2.1%, that means you’ll have to pay approximately $18,000 if you break your fixed rate mortgage. If you went with a variable mortgage instead, you’d have to pay 3 months of interest at 1.4%, which is a much lower $2,800. Note that even if the implied rate drops by 25 basis points, you’re still looking at around a $9,000 penalty on the fixed rate mortgage compared to $2,800 on the variable.
What I’d say right now is that it is a closer call between fixed and variable rates compared to before because we are expecting bigger jumps in rate hikes soon. This means that if you don’t anticipate that you’d need to break your mortgage contract and you’re looking to minimise your risk exposure, then a fixed rate can be a good option. But if you’re looking for the best expected option, variable rates are still better right now, and history tells us that variable rates do outperform fixed rates 70 to 90 percent of the time. Plus, if you’re looking to use the refinancing strategy to grow your real estate portfolio, you will also have the lowest expected total cost if you go with variable mortgages because of lower penalties.
The last thing going for variable rates for investors is that it does make more sense from a cash flow perspective as well. Rents do go up over time, and so it will be easier for you to carry your investment right now as you pay less interest when rents are lower. Then, in the future, higher future rents can potentially help balance out your higher future interest costs.
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