What Happens to Your Mortgage Payment if Interest Rates Go Up?

It’s a very legitimate concern, especially in today’s world of ultra-low interest rates and inflated real estate prices. Let’s take a closer look at this complex issue.

 

 

Although for most of the past 30 years it’s been a far better deal for Canadian mortgagors to take out a variable rather than a fixed rate loan, some 80% of borrowers still stick with a fixed rate.

 

In 2015, it’s actually easy to make the argument for going fixed – depending on your location, a five-year fixed mortgage will cost you less than 3% annually, which is just about as low as its ever been. Borrowers with good credit can get a one to four year mortgage for even less.

 

But in January, the Bank of Canada shocked the market by cutting rates 25 basis points to 0.75%. Although the major banks didn’t match the move completely -- the big boys cut their Prime lending rate from 3% to 2.85%, marking one of the few times ever they didn’t move in tandem with the Bank -- borrowers with variable rate mortgages are paying less than they were a couple of months ago. Economists are even predicting another rate cut for the spring.

 

Even in this environment of ultra-low interest rates, it’s still paying off to have a variable rate loan.

 

Still, many potential fans of variable are worried about what happens when rates go up for those borrowers. And unfortunately, there isn’t a set answer. Some lenders will allow you to keep the same payment and make a little less progress on the loan, while others will automatically up the payment accordingly.

 

It largely depends on how much equity you have in the home and how long the amortization of the mortgage is. If you only put down the minimum amount for a down payment and have the maximum amortization period, a lender won’t likely be willing to give you a break. But if you’re 15 years into a 25-year loan, it’s pretty easy to negotiate a steady payment throughout the term.

 

The standard in most mortgage contracts is that the payment will go up as rates go up, although some have ceiling rates. These rates are typically 2-3% above current rates, making it unlikely they’ll ever be reached. Essentially, they’re put in to appease nervous borrowers.

 

 

If you have a variable rate mortgage and interest rates start going up, there’s another option in addition to just paying the new rate.

 

Most lenders offer the choice to switch from a variable to a fixed-rate loan at no penalty. Here’s how it works -- if you have four years left on a five-year variable mortgage and decide to switch to fixed, you’ll ride out the term paying the lender’s four-year fixed rate. One year left and you’ll pay the one-year rate. And so on. All it takes is a phone call to your lender.

 

There are other steps you can take to minimize the pain of a five-year fixed rate. A popular option is to lock in to a variable term for three years, which lessens the time risk of being exposed to potentially rising interest rates. Variable rate mortgages for a one-year term also exist, although they’re few and far between.

 

Borrowers can also opt for one, two, or three-year fixed rates as well. These fixed rates are typically cheaper than on a five-year term, allowing the mortgage holder to get some benefits of lower rates while not taking interest rate risk.

 

I caution borrowers about predicting interest rates when choosing a term or type of mortgage. A year ago, the common refrain from economists was that Canada would likely raise rates in 2015. If the people who get paid to do this can’t get it right, what chance does the Average Joe have? Instead, focus on getting the right mortgage for your needs.

 

 

My advice is simple. For a borrower with a 25-year amortization and just 5% down, it’s probably better to go with fixed rates. Borrowers in that situation generally can’t afford to stomach the increased payments that will likely come with variable rates. But for borrowers with plenty of equity and who are well into their mortgage, variable is a cheaper option at this point.