Coping with mortgage rate stress

Variable or fixed with a stress test overlay

With interest rates climbing, homeowners with variable-rate mortgages may be wondering whether now is the time to convert to a fixed-rate mortgage. The answer is not as cut-and-dried as it might seem.

Long-term studies have shown that variable rate mortgages in fact save borrowers money because of their built-in discount on the mortgage rate. Mortgagors pay a premium on fixed-rate mortgages for the certainty of regular monnthly payments over the term. And it typically takes several rate hikes for the variable rate to climb above the rate for the fixed-rate mortgage. In addition, the penalty for breaking a variable-rate mortgage early is only three months’ interest. It’s typically much more for a fixed-rate mortgage (which you’d pay, for example, if you sell your house and break the mortgage or decide to refinance the mortgage). So in the shorter-term, the variable rate mortgage may be more desireable for those expecting to break their mortgage or increase it before the end of the term.

Those with a longer time horizon might consider converting to a fixed-term mortgage now if their budget cannot withstand an interest rate increase of say two percentage points within the next 12 to 18 months, as central banks continue to battle inflation by raising policy rates.

To make the decision rationally, you’ll have to do some number crunching. Once you’ve figured the costs of converting to a fixed-rate mortgage, including the interest penalty and legal fees (which usually apply if you go to a different lender), you’ll have to compare whether the interest payments you save by converting are greater than the combined penalties and fees you’ll pay.

If you have only a short time left on the term of your mortgage, it probably doesn’t make sense. If you have a longer-term mortgage, look at a difference in rates between your current mortgage and your proposed refinancing. A difference of more than one percentage point over, say, a 10-year term may be worth the effort, depending on the size of your principal of course.

First-time home buyers face an additional hurdle

Many new home buyers opt for variable rate mortgages, as payments are typically lower than for fixed-rate mortgages. But even that may not be enough. Home buyers shopping for a mortgage have an additional hurdle to jump: the so-called “stress test.” This raises the bar on your financial health a lot higher before you can qualify for a mortgage – even if you don’t have to be insured!

Anyone borrowing from a lender subject to federal regulation (and that includes just about every financial institution in Canada) will have to pass the OSFI Mortgage Stress Test in order to be approved for a mortgage. To qualify, you’ll need to afford the payments on a mortgage at the current contracted rate plus an additional two percentage points. And note, this applies to all borrowers, including those making down payments of 20% or more, who typically don’t need mortgage insurance.

Applied to the loan application, the stress test will look at such things as how much you’ll be able to afford with your current debt-to-income ratio, and whether you’d be able to continue making payments if interest rates rise or you lose your job. But the kicker is that even if you qualify for a mortgage at a current contracted rate today with a 20% down payment, you’d still have to qualify for a mortgage at an even higher rate, which is calculated as your current rate plus two percentage points, or 5.25%, whichever is greater.

If you don’t pass the stress test at the higher rates, you won’t qualify for the mortgage. Most at risk are those who have stretched their budgets to the limit in seeking the kind of house they want. For those in this position, the result is that you may be forced to revise your expectations and look for a lower-priced home.

With the variable -rate/fixed-rate decision becoming more urgent for many homeowners, the mortgage market can get complicated. The stress test rules have added another layer of anxiety to the mix. To avoid surprises, disappointments, and additional pressure at the lender’s office, check with your financial advisor before you sign on the dotted line. They’ll be able to give you a precise idea whether a variable or fixed-rate mortgage is best for your needs. For new home buyers, an advisor can also help determine what you can afford, whether you’ll pass the stress test, and how much you’ll be able to borrow.

Robyn Thompson, CFP, CIM, FCSI, is the founder of Castlemark Wealth Management, a boutique financial advisory firm specializing in wealth management for high net worth individuals and families. Contact her directly by phone at 416-828-7159, or by email at rthompson@castlemarkwealth.com for a confidential planning consultation.

Notes and Disclaimer

The foregoing is for general information purposes only and is the opinion of the writer. Securities mentioned are illustrative only and carry risk of loss. No guarantee of investment performance is made or implied. It is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. Please contact the author to discuss your particular circumstances.