With all the planning and preparation we do to buy our Big Asset, we want to make sure there’s a plan when it comes to managing it.
Lately, I’ve been getting a lot of questions about interest rates, especially as the Bank of Canada begins to increase them.
It’s not bad to worry about rising interest rates. No one wants to be paying more interest if they don’t have to. But, there is a caveat to that.
It’s not always the lowest interest rate that saves you the most money.
I have a few strategies to help you manage your mortgage with rising interest rates so that you aren’t only ready for the eventual increase, but you’re ahead with building equity in your Big Asset.
Strategy #1: Stay Variable
When the Bank of Canada discusses raising the Overnight Rate, variable-rate mortgages and lending products are affected. Fixed-rate products are not affected by the Overnight Rate (more on that later).
Most interest rates on variable-rate mortgage products use the Prime Lending rate. This is the rate banks use to set their lending rates and is slightly higher than the Overnight Rate. The difference is the bank’s profit.
Most variable interest rate products are set at the Prime Rate - 1%. Meaning, that if the current Prime Rate is 3.2%, then a variable interest rate could be 2.2% or lower.
Overnight Rate: The Overnight Rate is the interest rate at which large banks borrow money among themselves, typically in the overnight market. The Bank of Canada sets this rate to help manage Monetary Policy.
Prime Rate: Prime Rate is the interest rate banks use when lending to their clients. They can decide what this rate is, but it will typically follow the same movement as the Overnight Rate. If the Overnight increases by 1%, Prime Rate will do a similar increase, although maybe not at the full 1%.
The biggest risk with a variable rate mortgage is that as the Overnight and Prime rates increase, so does your mortgage payment. This increase to cover the additional interest expense can cause a lot of homeowners to panic.
However, the math still works in favor of the homeowner with a variable mortgage.
$300,000 Mortgage (25 Year Amortization) | Variable Rate (April 13, 2022) | Fixed Rate at 4.5% |
Prime Rate | 3.20% | - |
Variable Rate* | 2.20% | - |
Mortgage Payment | $1,299.49 | $1,660.42 |
Difference | | $360.93 |
*Variable rate can change based on if your mortgage is high ratio or conventional mortgage.
Even with the slight increase in your variable rate, you are still significantly paying less than you would in a fixed-rate mortgage.
Myth: There’s a common myth that payments on a variable rate mortgage change monthly, however this isn’t the case. For the last two years, rates have not changed at all, meaning payments remained the same. When interest rates change, they will remain until another change occurs. There are eight Bank of Canada meetings annually, but rates rarely change at every single meeting. Currently we’re experiencing a faster increase to bring us back to pre-Covid lending rates.
Strategy #2: Increase Your Monthly Payment Amount
The best way to manage your mortgage among rising interest rates is to get ahead of the future rate increases.
One reason I really like variable rate mortgage products is they typically come with flexible prepayment privileges. This means, you can put more money on the principal of your mortgage without penalty.
Most lenders will allow you to prepay up to a 20% lump sum of the original mortgage amount or a 20% payment increase. For example, if you add an additional 20% to your monthly payment, you are still $100 lower monthly than paying a fixed rate.
$300,000 Mortgage (25 Year Term) | Variable Rate (April 13, 2022) |
Prime Rate | 3.20% |
Variable Rate | 2.20% |
Mortgage Payment | $1,299.49 |
20% Prepayment Amount | $259.90 |
Total Payment | $1,559.39 |
Difference From Fixed Rate | $101.03 |
And are you ready for the mic drop? If you paid an additional $259 on your monthly mortgage payment—which goes straight to your principal—you would reduce your mortgage amortization to 19.77 years.
Meaning, you would reduce your amortization by just over five years! And who wouldn’t mind $1,500 of additional monthly cash flow?
Strategy #3: Change Payment Schedule
Another way to manage your Big Asset is to change your payment schedule. It’s a similar strategy to increasing your monthly payment.
Accelerated Bi-Weekly: With this payment schedule, you make a mortgage payment every two weeks. The amount is slightly higher than your regular bi-weekly payments.
Because there are 26 weeks in a year, you would be making the equivalent of an additional monthly mortgage payment per year.
Accelerated Weekly: Similar to an accelerated bi-weekly, you would pay a slightly higher amount every week. You would still be making an additional mortgage payment per year.
Strategy #4: Make a Lump Sum Payment
Did you get a tax refund this year or have found a bit of extra income? Put it on your mortgage! Again, any payment above your regular payment goes straight to your principal.
You’ll have to check with your mortgage lender to determine your payment privileges since there may be a limit as to how much you can pay in one year. But, even the smallest payments have a strong impact on your balance.
Fixed-Rate Mortgages
As mentioned above, interest on fixed-rate mortgages are set differently than variable rates.
The interest rate on fixed-rate mortgages are influenced by the Canadian Bond Market. When the yields on bonds are increasing, so will the interest rate on fixed rate mortgages.
Both bonds and fixed rate mortgages generate profits for a bank, however, a mortgage is a much higher risk than a bond. Banks forecast what their earnings from the bond market will be and use fixed-rates to cover any costs or potential losses.
Currently, the industry average for 5-year fixed-rate mortgages is 4.50%. This is significantly higher than a 5-year variable rate mortgage, even with the latest increases in Prime Rate.
Fixed-rate mortgages do offer the comfort of an unchanging payment throughout your term. Most lenders do offer an option to their variable clients to switch to a fixed-rate free of charge. However, it will be at the interest rate at the time of your request.
The Math They Should Have Taught In School
When talking about managing your money, you have to let the math show you the way.
With the difference between variable and fixed rates (approximately 2%), and the advantages of your lender’s prepayment privileges, would you rather your money go into your Big Asset rather than the lender’s pocket?
Whenever we look at taking a variable rate mortgage, the same with fixed rates, you always want to make sure you have a payment strategy. Luckily, I like doing this kind of math and get excited showing folks what they can do within their mortgage.
Before you make any change to your mortgage, give me a shout. Let’s figure out the math and see what you’re comfortable with to help you manage and grow your Big Asset!