Can you afford a variable rate mortgage? How to do your own financial fitness test

Rising interest rates bring to the fore a difficult personal finance question: How much room in your budget do you need to modify your mortgage?

An oft-cited 2001 study by York University finance professor Moshe Milevsky shows that between 1950 and 2000, variable-rate mortgages beat fixed-rate mortgages 88 percent of the time when it comes to saving on borrowing costs.

But after six consecutive rate hikes by the Bank of Canada, today’s environment could turn out to be more than the 12 percent part of history when floating rates didn’t come out on top, Professor Milevsky told The Globe and Mail.

See how rising interest rates affect your mortgage costs

Canadians haven’t given up on variable rates, however – according to a report by housing analyst Ben Rabidoux, variable rate mortgage originations were still higher in August compared to pre-COVID levels. If interest rates begin to fall in the coming months, Canadians who choose the variable today could do better. But borrowers considering a variable rate should always make sure they’re financially sound, even if their timing is bad. However, how to do it is far from simple.

Mortgage brokers often recommend that borrowers choosing a variable rate have plenty of wiggle room in their budget so they can afford rate hikes. The interest rate on an adjustable-rate mortgage usually follows the movements of the Bank of Canada’s trend-setting key interest rate. With fixed mortgages, on the other hand, the interest remains the same for the duration of the mortgage, usually one to ten years, giving the borrower more time to adjust to the rise in interest rates.

But the central bank’s recent interest rate hikes raise the question of what exactly is an appropriate amount of budget reserves. The key interest rate has risen from 0.25 percent at the beginning of March to 3.75 percent. Interest rate hikes went further – and happened faster – than economists expected at the start of the year.

On a mortgage with a balance of $380,000 — roughly the average for first-time home buyers to borrow in 2020 and 2021 — these rate hikes mean a cumulative payment increase of nearly $745 per month for some borrowers.

And while most Canadians have variable-rate mortgages, where payments normally remain fixed even as the interest rate changes, some of these borrowers are also experiencing financial pressure. This is because the loans are starting to reach the so-called their “trigger point”, the threshold after which regular monthly payments no longer cover the debt and lenders often start demanding higher payments.

One possible approach for the prudent borrower could be a long-term average of the prime rate, which lenders use to set interest rates on variable-rate loans, said David Field, a certified financial planner and founder of Papyrus Planning.

Borrowers could aim to set aside an amount for mortgage costs equal to the payment they would face if their interest rate were equal to the historical average of the prime rate, Mr. Field said. If their actual mortgage rate is lower than this, they could use the extra cash to make mortgage payments and pay down their principal more quickly. If they hit their prepayment limit, they could save the extra in a savings account that could serve as a reserve fund they could tap into if interest rates rise above the historical average, he added.

But with home prices as high as they are today, only higher-income borrowers could afford such a strategy in Canada’s most expensive market, Mr. Field noted. “It’s not a middle-class thing,” he said.

Since the beginning of 1960, the monthly average of prime interest rates has been around 7 percent. For comparison, current five-year variable rate mortgages are in the 5 percent range.

Professor Milevsky recommends that borrowers put their finances through an extensive stress test when choosing between fixed and variable interest rates.

If you had a large down payment and a relatively small mortgage, or you’ve already made good progress in paying down the principal, you’re less sensitive to interest rate increases, he noted. Stable and predictable income also makes it easier to manage rising borrowing costs, he added.

“It’s risky to go into a convertible without at least four to six months of cash for living expenses,” said mortgage strategist Robert McLister. “The last thing you want is for rates to go through the roof — like they did this year — and then have emergency expenses or lost income when your payments go up.”

The financial fitness test for a variable rate mortgage is a bit of a check box, as prof. Milevsky describes it. If you check most of the boxes, you’re a good candidate for a variable rate, he said.