Life is becoming quite expensive. You see it on your news feed, experience it at the gas pumps and in your local grocery store—everything keeps going up, and there’s no sign of relief.
Unfortunately, this means your mortgage will likely be affected by inflation. Read on to learn what inflation will do to your mortgage and the steps you can take to soften the blow.
What’s the Connection Between Mortgage Rates and Inflation?
When your economy is healthy, a small amount of inflation is a natural occurrence. It’s when inflation rises too quickly that it starts to wreak havoc. The dollar’s value sharply drops as prices rise, and if the Bank of Canada (BoC) doesn’t intervene, a recession is possible.
The BoC has a maximum targeted inflation rate of 2% per year to avoid recessions. They keep this target in mind when the overnight interest rates rise. The overnight rate is the amount it costs the banks to borrow from each other over a single night.
The way it’s supposed to work is, the banks raise interest rates to offset their costs due to the rise in the overnight rate. The higher the interest rates are, the less likely people will borrow money. As a result, people are more apt to curb their spending, which affects the supply and demand of goods and services, decreasing prices and slowing inflation.
How Does a Variable Mortgage Work?
Interest fluctuations affect a variable mortgage because they relate to the bank’s prime rate. A variable mortgage rate uses the current prime rate minus 1.3%. For example, if the prime rate sits at 3.2%, your variable mortgage rate would be 1.9%. If the overnight rate jumps .25%, banks change their prime rate accordingly.
Doing the math looks like this:
3.2% + .25% = 3.45% – 1.3% = a variable mortgage rate of 2.15%.
How Does a Fixed Mortgage Work?
Interest rate changes don’t affect a fixed mortgage. Once the term is due for renewal, the rate will change. A fixed mortgage rate is based on bond yields, not the prime interest rate. Rising prime interest rates during inflation have a ripple effect on bond yields over time.
For example, if the prime rate increased yearly over a five-year fixed mortgage term, bond yields would be somewhat affected, which would increase the next five-year fixed mortgage rate.
What do the Rising Rates Mean for Your Existing Mortgage?
If you choose a variable-rate mortgage, pay attention to your bank statement. You’ll see your payments increase every time the prime rate rises. This will continue as long as interest rates keep climbing.
Paying higher mortgage payments may hurt a bit, but that’s the sacrifice of having a variable mortgage. Over five years, you’ll still likely pay less than you would on a fixed mortgage.
If you choose a fixed mortgage, your payments remain the same until renewal. So, for example, if in five years the fixed-rate climbed 1%, your payments will look like this:
Your previous fixed-rate mortgage of 2.49% with a monthly payment of $2,500 changed to a renewal fixed-rate mortgage of 3.49%, making the monthly payment $2733. This equates to $233 more per month x 60 payments = $13,980 over the next five years.
Should You Think About Switching to a Fixed Mortgage?
The reason for choosing a variable mortgage in the first place is usually to pay less overall for your home. But when inflation hits, causing interest rates to steadily rise along with your payments, you may question if you made the right choice.
The most significant benefit of switching your variable mortgage to a fixed mortgage is the peace of mind it brings, knowing that your payments won’t change for five years. But saving you money, in the long run, is not likely.
Since a variable rate is approximately 1.5% less than a fixed rate, it would have to rise significantly within the five-year term to make switching to a fixed-rate worth it.
Here’s how it would look if the prime interest rate went up .75% every year for five years:
Fixed-rate is 3.5%.
The first-year variable rate is 3.5% less 1.5% = 2%
Now add .75% per year.
- Your second year is now at 2.75%
- Your third year is at 3.5%
- Your fourth year is at 4.25%
- Your fifth year is at 5%
The average with the 3% increase works out to 3.5%, just like the fixed-rate mortgage, so it still wouldn’t be a cost-saving decision to switch to a fixed-rate mortgage.
History shows that fixed-rate mortgages rarely beat variable-rate mortgages. But without knowing the full effect this inflation period will have on mortgages, it could fall into the “rarely seen before” category.
4 Strategies You Can Use to Prepare for Higher Mortgage Rates
For most of the ’70s and ’80s, mortgage rates hovered between 10%-12%, with a short period of spikes into the 20% range. The interest rates declined from there, and in 2020, they bottomed out at under 2% for a five-year fixed rate. However, Canada’s economy started recovering from the pandemic in 2021, and the interest rates are rising again. In addition, other global affairs are contributing to the inflation we see today, and it’s quite possible interest rates could hit 10%-12% again.
Here’s how to prepare for the inevitable rising costs of mortgage rates:
Strategy #1: Make Extra Mortgage Payments Now
The sooner, the better. If you can afford extra payments, do it. The extra money goes toward your principal—saving money on interest and paying off your home faster. This practice also prepares you for when your payment increases. Prepare for the future by using a mortgage calculator to figure out what payments with a higher interest rate will be. Until your rate rises, you can stop making additional payments at any time.
Strategy #2: Early Fixed-Rate Renewal
If you’re locked into a fixed-rate mortgage, see if your lender will allow you to renew early. Depending on the time left on the term and what kind of a customer you’ve been over the years, your lender may allow you to renew early without penalty. So although your new rate will be higher, it may not be as high as it could be if you left it for the entire term—and you’ll be safe from rising rates for another five years.
Strategy #3: Your Fixed Mortgage up for Renewal? Switch to Variable
Consider switching to a variable-rate mortgage when your fixed-rate mortgage is up for renewal. Variable rates are traditionally 1.5% lower, which means you save money in the short term while you see what’s trending with the rates. This is a low-risk move since most variable-rate mortgages are convertible to fixed-rate at any time.
Strategy #4: Contact Your Lender or Broker
Speak with your lender or broker to let them know your concerns. By proactively reaching out, they’re usually more receptive to helping you. For example, if you’re concerned that you may not keep pace with your payments because of steadily climbing rates, most lenders will work with you to find a solution so you can keep your home.
Looking to Buy a Home During the Rising Costs of Inflation?
Canadians have enjoyed low-interest rates for years, but it looks like that luxury may be coming to an end.
If you’re in the Toronto or GTA area and looking to buy a home but not sure how to navigate the everchanging market, Joel Cooper can help.
Overwhelmed homeowners have been working with Joel for over 14 years and trust him to give the best advice regarding their mortgage concerns and housing needs.
Get in touch today to get started.
Hi, I’m Joel, a real estate professional based in Toronto.
My approach is simple—I put you first. I believe in open communication, total transparency, and meaningful results. I’ll guide you through the real estate process, market values, and always keep the focus on you—and your needs.