Rising Interest Rates and Your Mortgage

The Bank of Canada recently announced another interest rate hike.  The overnight rate (which banks use to determine their prime rate) has climbed 1.25% so far in 2022 with rumours of more increases to come.

But how do these rising interest rates impact your mortgage? Well, like most things with personal finance, it depends.  In this case, the type of mortgage you have will determine the impact the Bank of Canada decisions will have on you.

So, let’s dive in and talk about all things mortgages and how they are impacted by rising interest rates.

Fixed vs Variable – What’s the Difference?

When it comes to mortgages in Canada there are 3 main types, fixed, variable, adjustable, and a fourth hybrid option.

Fixed Rate Mortgage

Fixed rate mortgages (FRMs) are exactly that, they have a fixed rate throughout the term of your mortgage.  Because the rate is fixed it doesn’t change if the prime rate changes. And your length of amortization (how long it takes you to pay off the loan) is also consistent.

Interest rates for fixed rate mortgages are determined based on bond rates, not the Bank of Canada overnight rate.

Benefits of Fixed RatesDisadvantage of Fixed Rates
– Rate (and payment) are consistent throughout term
– Consistent amortization
– Larger penalties if you break your mortgage
– Typically rates are higher than variable rate mortgages

Variable Rate Mortgage

Variable rate mortgages (VRMs) have an interest rate that changes based on the prime rate.  The prime rate is the annual interest rate set by banks and used to calculate mortgage interest rates. Although a bank’s prime rate is not 100% tied to the Bank of Canada overnight rate, they are typically highly related.

With a variable rate mortgage your payments stay the same throughout your term.  But if the prime rate changes, so does the amount of your payment that goes towards the principal of the loan.

So if interest rates increase, more of your payment will go towards interest therefore lengthening the amortization of your loan.

But if interest rates decrease, more of your payment will go towards the principal which may decrease the length of time it takes you to pay off the loan.

Benefits of Variable RatesDisadvantages of Variable Rates
– Lower penalties for breaking the mortgage
– Typically have lower rates at start of term
– More interest paid if rates go up
– Amortization increases if interest rates increase

Adjustable Rate Mortgage

Adjustable rate mortgages (ARMs) have some of the advantages of both fixed and variable rate mortgages. They do exist in Canada, but are not as common as the previous two types.

Similar to a variable rate mortgage, the interest rate of an ARM is tied to the bank’s prime rate.  If the prime rate goes up or down, so does the interest rate. But where an ARM is different from a VRM is that with an adjustable rate mortgage, your payment changes with an interest rate change, but your amortization stays consistent (similar to a fixed rate mortgage)

Benefits of Adjustable RatesDisadvantages of Adjustable Rates
– Lower penalties for breaking the mortgage
– Amortization stays consistent
– Payment changes with interest rate changes
– Not offered by every lender

Hybrid Mortgage

A hybrid mortgage usually has part of it locked into a fixed rate and part of it floating with a variable rate. So they have a combination of the characteristics above depending on how they are specifically structured.

Infographic showing affects of interest rate changes on your mortgage

How Do Rising Interest Rates Impact Your Mortgage?

Now that we’ve talked about the general characteristics, here is how rising interest rates impact each type.

  • Fixed Rate Mortgages not immediately impacted by rising interest rates.
  • Variable Rate Mortgages – rising interest rates will prolong the amortization of the mortgage, making it take you longer to pay off the loan if you make no changes. And 
  • Adjustable Rate Mortgages – with an increase in rates, your payments will also increase, to keep the amortization consistent.

Regardless of the immediate impact of rising interest rates, each mortgage type will be impacted upon renewal.  According to the Bank of Canada, some mortgage holders could see their payments increase by as much as 45% in the next 5 years. 

Holders of variable rate mortgages are especially susceptible to large payment increases as rates will be higher and lenders will be wanting to re-align payments to the original amortization schedule.  Remember that payments don’t change with a VRM when interest rates change, but the amortization (or total length of time to pay off the loan) is affected.

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Which is Better: Variable Rate Mortgages or Fixed Rate?

The answer to this question is going to depend on your financial goals and comfort level.  

Are you trying to pay off your mortgage as fast as possible? Would a fluctuating mortgage rate cause you stress? The answers to these questions can help guide your decision.

But remember, when it comes to deciding what type of mortgage to get, there is more than just the rate to consider.

When shopping around for a mortgage, ask about other conditions of the mortgage besides just the rate.  Here are few things to consider when trying to decide:

  • Prepayment allowed
  • Available length of amortization
  • Penalty for breaking mortgage
  • Portability
  • Fees
  • Readvanceability
  • Pre-approval amount

If you are trying to pay off your mortgage as fast as possible, then you will want to find a product that has a large prepayment allowance and a low interest rate.

But, if fluctuating mortgage rates cause you stress then a fixed rate mortgage may be a better option.

The type of property you are borrowing against may also impact the type of mortgage you choose.  The interest paid on a rental property can be a tax deduction but the same cannot be said for your primary residence (unless you get creative).

As you can see, there is a lot to consider when choosing a mortgage.  The first step is to try and determine what your financial goals are. And then choose a product that aligns with them.

With Rates Rising, Should I Lock In My Mortgage?

This is probably one of the most common questions homeowners have right now.  Most variable rate mortgages have an option to lock in at a fixed rate for the remainder of the term.

But is locking in your mortgage a smart move, even with rates increasing?

Does History Repeat Itself?

In 2001, Moshe Milevsky published an often referenced study sharing his findings that between 1950 and 2000 variable rate mortgages beat fixed rate ones 70-90% of the time.  Meaning, that if you went with a VRM you would have paid less interest than a FRM.

I’ve often heard that historically variable loans beat fixed. I’ve even shared this fact publicly many times.

But looking into it a bit deeper, things aren’t always as they seem.  Yes, from 1950 to 2000 if you went with a VRM over a FRM you would have paid less interest. 

However, history doesn’t always repeat itself.  In fact, for the past few years we have been living in “unprecedented times. ” So when it comes to personal finance, previous performance is not indicative of future returns.

Pay Attention to the Spread

If history is not a good clue, then let’s look at current rates to help try and answer this question. 

At the time of writing, the current “best” posted  5-year fixed rate in Canada according to ratehub.ca is 3.69% and the 5-year variable rate is prime -1.3%, or 2.4%.

So if you had a VRM and locked it in now you would be guaranteeing yourself a rate increase to 3.69%. But every month you don’t lock in, at the current rates you are ahead 1.29% (3.69%-2.4%).  

Could interest rates rise more than 1.29% before the end of your loan, absolutely. But it’s not guaranteed. 

And they would have to stay at that elevated rate for longer than they were at the lower rate for the fixed rate to come out ahead.

interest rates example written on the back of an envelope
A little back of the envelope example

So right now, even with interest rates rising, because of the current spread we have on our mortgages (on our primary residence and our rental properties) we are not locking in any of our rates.  But that’s just what we are doing – you need to do what is best for you and your financial situation.

Being Able to Sleep at Night

The sleep at night factor is often not discussed in the personal finance space, but is really important to consider. Especially when it comes to something as big as your mortgage.

If rising interest rates have you stressed out and you would sleep better at night with a fixed payment and amortization, then locking in your rate may make sense for you. Not every financial decision you make has to be hyper-optimized.

But if you can sleep just fine with the fluctuation in rates when maybe you don’t need to lock in your rate right now.

If you are feeling stressed take some time to check in to determine what is causing that stress and how you can help to alleviate it. Because at the end of the day, we all need a good night’s sleep.

Expense Tracking Workbook opt in graphic

Final Thoughts

As you can see, how the rising interest rates will impact your mortgage depends on the specifics of your loan. Some people may be fine with an increased amortization, while others will want to be rid of their mortgage as soon as possible.

Hopefully, this helps to clarify how the Bank of Canada’s decisions may affect you personally.  Nobody knows with 100% certainty what the future will hold.  All you can do is make the best decisions with the information you have at the time.

As for us and our 10 mortgages, some of them already are in fixed products. And we have no intention of changing any of our variable and adjustable rate mortgages for the time being.

If you’re wondering how the rising interest rates will affect your mortgage and I haven’t answered your question, please leave it in the comments and I would be more than happy to address it.

2 thoughts on “Rising Interest Rates and Your Mortgage”

  1. Very informative. I had been misinformed about variable rate mortgages. I thought if rates increase, your payment immediately went up to make up the difference.

    Also loving that your “back of the envelope” math was literally on the back of an envelope!

    1. Thanks AL – I think it’s a common misconception about variable rate mortgages and payment changes.

      I often write on the back of envelopes so thought I would share;)

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