We are all currently reeling with rising costs of living (primarily gas and food) and rising interest costs as Bank of Canada raises the borrowing costs to tackle the former. The outlook for the immediate future appears much uncertain and not as envisioned only couple of months ago. While these factors have an impact on all of us, the degree of impact is not the same. Some people are getting more hurt than others and if you are one of them, I am sure you are looking for ways and means to lessen the financial impact of these developments. I empathize with your situation and want to equip you with adequate information about possible options and potentially avoid critical errors in judgement.
In a series of posts over coming weeks, I will try to address a couple of different scenarios and what you should be considering if such a situation applies to you. The question that I will address in this post is regarding the suitability of Variable Rate Mortgage and who should NOT consider such a product. The recommendations in this post are most appropriate for somebody who is either buying a property now or currently has a Variable Rate Mortgage. Recommendations are generic and you should consult a professional before taking action. Do leave your comments and let me know of any scenarios that you want addressed.
Over the last couple of decades Variable Rate mortgages have cost the borrower lesser as compared to Fixed Rate mortgages of the same duration as interest rates have been in a declining trend (Monthly chart of Canadian Bond Yields is a good proxy). There are several factors which appear to support that long term trend. These factors include:
1. Technological advances which continue to improve productivity
2. An aging population in the western hemisphere which naturally reduces spending and growth prospects
3. Accommodative monetary policy of central banks to encourage growth
4. High savings rate in Asian emerging countries and its search for haven investments, which in turn reduces the cost of capital in the target markets
But while this appears to be true in the long run, there were instances when interest rates rose in the short term. You can refer to the same chart to find such instances in 2000 (internet bubble), 2010 (following expectation of economic recovery after the 2008 financial crisis) and 2017-18 (central bank started raising policy rate). Also, the above mentioned factors themselves are not constant or their impact steady over time and thus the result is subject to change over time.
All of this inherently implies that the path is not straight and that anybody borrowing on such variable terms should be capable of enduring such financial twists and turns. From my perspective, a borrower who exhibits one or more of the following characteristics is not in the best financial and or emotional state of mind to undertake what can be a rollercoaster ride from time to time and hence should avoid borrowing against a Variable Rate mortgage or Home Equity line of Credit and more so in an inflationary environment.
Has had to take on a Variable Rate Mortgage because they would NOT have qualified to take on a Fixed Rate Mortgage due to higher stress test requirements
Has a credit score below 650 as it possibly indicates somebody who has had or is having challenges making timely and or minimum payments; and or has or had been using a significant portion of the credit (30% or more) available to them
Mortgage payment is/will be significant portion of monthly income (25% or higher of net income) and owners' equity is less than 10%~15% in their primary home. The equity requirement should be significantly higher in places which have witnessed a significant jump in prices since 2020, say 40% or higher. For investment properties, the equity should be higher at about 30~35% and hopefully these properties are cashflow positive or neutral.
Have a conservative approach and cannot endure any fluctuation in payments/interest costs etc. Other clues are: Generally, park savings in GIC/cash/Bonds or cannot endure more than 20% decline in the value of equity/stock investments
If the above characteristics apply to you and you currently have a variable rate mortgage, then I would strongly advise that you consider switching over to a Fixed rate mortgage of 2-to-3-year term shortly. While this will most certainly lead to an increase in your monthly payment (as the rate difference is possible 1% to 1.5%), you will remain protected from possibly significant increase in Prime Rate from then on. The downside side risk is that the Prime Rate does not rise above 5.20% (currently at 3.70%) or doesn’t stay above this level for 12 ~ 18 months if it rises above 5.20%.
Hope this helps you make the right decisions for the wellbeing of you and your family and do consult with a professional before you take any action.
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