The Re-Emergence of the Variable Rate Mortgage & How to Refi to Save Money Now

More Canadian homeowners are exploring the option of switching from fixed-rate to variable-rate mortgages following a significant interest rate cut by the central bank on Wednesday, according to mortgage brokers. The Bank of Canada reduced its benchmark policy interest rate by 50 basis points to 3.75%.  In turn all of the Big Six Banks lowered their Prime Rate to 5.95%  providing relief to homeowners after years of rising mortgage payments and increased living costs.

Most mortgages in Canada renew every three or five years and typically amortize over 25 or 30 years, which exposes borrowers to fluctuating rates. Homeowners generally choose between fixed-rate mortgages, which are affected by bond prices, and variable-rate mortgages, which benefit when policy rates decrease.

For example, switching to a variable rate could save homeowners an average of $4,500 on a $400,000 mortgage, even after accounting for penalties of up to $4,800 for breaking and refinancing the mortgage. HuronMortgages.ca can help clients calculate these penalties, especially as recent policy changes offer consumers greater flexibility to switch lenders and secure lower rates.

Variable-rate mortgages have been gaining traction since the central bank began cutting rates in June. As of the first quarter, 12.9% of new mortgage borrowers chose variable-rate mortgages, a significant increase from just 4.2% in the third quarter of 2023, according to the latest Bank of Canada data.

HuronMortgages.ca has been advising clients to consider short-term variable-rate mortgages and regularly calculates potential savings for existing clients contemplating a switch to fixed rates as interest rates decline further.

Refinancing:  How to Determine Your Penalties:

A mortgage refinance penalty is applied when you change your mortgage before the term ends. In Canada, this penalty is calculated as the higher of 3 months’ interest or the Interest Rate Differential, depending on your lender, mortgage product, and term length.

For Variable Mortgage rates, the penalty is always 3 months’ interest, while for fixed-rate mortgages, it is typically the greater of the two calculations.

Interest Rate Differential Clarified

The mortgage interest rate differential (IRD) is a penalty calculation used by lenders when you break a fixed-rate mortgage before its term ends. It represents the difference between your current mortgage rate and the lender’s current posted rate for a similar mortgage term.

Here’s how it works:

1. Current Rate Comparison: When you decide to refinance or pay off your mortgage early, the lender compares your existing interest rate to the current market rate for a new mortgage of the same type and term.
2. Calculating the Differential: The IRD is calculated by subtracting your mortgage rate from the current posted rate.
3. Penalty Amount: The resulting difference is then multiplied by the remaining balance on your mortgage and the remaining term in months to determine the penalty amount.

For example, if you have a mortgage rate of 3% and the current market rate for a similar mortgage is 5%, the IRD would be 2%. If your remaining Mortgage balance is $200,000 and you have 12 months left on your term, the penalty would be calculated as follows:

Penalty = (IRD × Remaining Balance × Remaining Months)

Penalty = (2% × $200,000 × 12) = $4,800

The IRD is often higher than the flat penalty of 3 months’ interest, which is why it’s important to understand how your lender calculates penalties when considering refinancing or paying off a mortgage early.

3 Month Penalty Formula

Current Mortgage Principal x Original Interest Rate / 12 x 3

Penalty = 200,000 x 5% / 12 / 3 = $2,500

Reasons For Breaking Your Mortgage Before Maturity To Save Money

Breaking your mortgage to save money with a new rate involves refinancing your existing mortgage to take advantage of lower interest rates or better terms. Here is how it works:

1. Identifying Lower Rates

If market interest rates decrease significantly since you took out your mortgage, you may find that refinancing to a new mortgage with a lower rate could lead to substantial savings on your monthly payments.

2. Calculating Potential Savings

To determine if breaking your mortgage is financially beneficial, calculate the difference between your current mortgage rate and the new rate. For example, if you are currently paying 4% and can refinance at 3%, this difference can reduce your monthly payment and total interest paid over the life of the loan.

3. Assessing Penalties

When you break your mortgage, especially if it is a fixed-rate mortgage, lenders typically impose a penalty. This is often calculated using either three months’ interest or the interest rate differential (IRD). You will need to factor this penalty into your overall savings to ensure that the benefits of refinancing outweigh the costs.

4. New Loan Terms

When refinancing, you may have the opportunity to adjust the terms of your mortgage, such as the length of the loan or the type of rate (fixed vs. variable). A shorter term could mean higher monthly payments, but less interest paid overall.

CONTACT HURON MORTGAGES AT MATT@HURONMORTGAGES.CA NOW

Bond yields, not the Bank of Canada, dictate fixed-rate mortgage rates.

Many people mistakenly believe that the Bank of Canada directly controls all mortgage rates. While it does have an impact on variable mortgage rates, most Canadians who choose fixed-rate mortgages are influenced more by bond yields than by the BoC’s overnight rate. Fixed-rate mortgages are widely popular and closely linked to government bond performance, particularly the five-year bond, which has been declining since April 2024.

The bond market is currently predicting fewer rate cuts ahead, but this view may be influenced by the upcoming U.S. election. It seems unlikely that the Federal Reserve will take significant actions before the election, as those decisions could become overly politicized.

As a result, we may need to wait until after the U.S. election to gain a clearer understanding of how bond yields and interest rates will behave in 2025. It is essential to consider how the Bank of Canada keeps an eye on Federal Reserve actions to grasp the bigger picture.

The Impact of the U.S. Federal Reserve on Canada’s Lending Market

After the Bank of Canada’s 50 basis point cut, the interplay between Canadian and U.S. monetary policy becomes crucial. The BoC must consider the Federal Reserve’s actions to prevent a widening policy gap; if the BoC cuts rates further while the Fed holds or raises rates, the Canadian dollar could weaken, raising import costs and potentially increasing inflation in Canada.

To mitigate this risk, the BoC will proceed cautiously and closely monitor the Fed’s decisions, aiming to keep the Canadian economy competitive while controlling inflation. Although exports are contributing more to Canadian GDP, the country lacks a strong export-driven economy compared to past recessions, limiting its ability to capitalize on this trend.

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As a specialist in real estate and mortgage financing, I’m dedicated to supporting you on your financial journey. At HuronMortgages.ca we specialize in refinances, purchases, self-employed clients, bruised credit, and construction projects. If you’re open to a brief, no-obligation call or Zoom meeting at your convenience send an email to Matt@huronmortgaes.ca.