With interest rates soaring, why do so many borrowers still choose variable-rate mortgages?


Federal rules aimed at taming financial risk in the mortgage market are giving some home buyers an incentive to choose variable rates despite rapidly climbing interest rates, some brokers say.

The bar to clearing Ottawa’s mortgage stress test is currently likely to be lower if you choose a variable mortgage than if you commit to a fixed rate. That, in turn, means a variable rate allows you to qualify for a larger mortgage.

“It’s fairly counterintuitive, I would say, since fixed rates are more stable, less risky,” said James Laird, co-chief executive officer of Ratehub Inc., which runs the financial products comparison site Ratehub.ca and has its own in-house mortgage brokerage.

“It’s unusual, and, I would expect, this situation we’re in was not intended by the policy makers,” Mr. Laird added.

The mortgage stress test mandates that federally regulated lenders vet borrowers’ finances against rates higher than the mortgage rate offered by their lender. The aim is to ensure they’d be able to keep up with payments even if interest rates were to rise substantially above their current mortgage rate.

Currently, borrowers must qualify based on the higher of either a benchmark rate of 5.25 per cent or their contract rate plus two percentage points.

With five-year variable rates in the 2-per-cent range and many five-year fixed rates at around 4 per cent, the rules mean that variable-rate borrowers must only meet the 5.25-per-cent threshold while many fixed-rate mortgage applicants are facing a qualifying rate of 6 per cent or more, said David Larock, a Toronto-based mortgage agent with TMG The Mortgage Group.

Each percentage point increase in the stress-test threshold reduces the maximum amount home buyers can borrow by roughly 10 per cent, Mr. Laird said.

That’s why buyers who need to borrow the maximum allowed to afford their desired property are often choosing variable rates these days, despite the risk from climbing rates, he added.

RATESDOTCA, which allows Canadians to compare mortgage and other rates online, said about half of the mortgage inquiries it’s receiving right now are about variable rates.

Federal regulators introduced the current 5.25-per-cent minimum qualifying rate as a new and higher floor for the stress test in June, 2021, amid widespread concern about an overheating housing market fuelled by record-low borrowing costs. The latest stress test rules apply to both insured mortgages – those with a down payment of less than 20 per cent, which require mortgage default insurance – and uninsured loans with larger down payments.

The Office of the Superintendent of Financial Institutions (OSFI), which oversees the stress test for uninsured mortgages, has committed to reviewing the qualifying rate at least once a year, every December.

However, both OSFI and the Department of Finance, which oversees stress test rules for insured mortgages, left the floor rate unchanged in December, 2021.

In comments to The Globe and Mail, OSFI rejected the notion that stress test rules are the reason for the enduring popularity of variable rates among borrowers applying for uninsured mortgages.

“In the current rate environment, borrowers who choose variable rate mortgages do so, overwhelmingly, because they can potentially cost significantly less than a fixed rate mortgage. Cost and risk appetite are the primary explanatory factors for borrowers’ choice of variable rate mortgages in the uninsured space,” the regulator said via e-mail.

While the stress test formally applies only to federally regulated lenders such as banks, even provincially regulated lenders such as credit unions use those metrics to vet mortgage applicants for their most competitive rates, Mr. Larock said. Not doing so would give borrowers who don’t qualify under the federal rules an incentive to flock to credit unions, which would increase financial risk for those lenders, he added.

Variable rates usually move up or down following adjustments in the Bank of Canada’s trendsetting overnight rate. Many analysts expect the central bank to lift its key rate from its current level at 1 per cent up to 2.5 per cent by early 2023 in an effort to tame rampant inflation.

Many variable-rate mortgage holders in Canada have fixed payments. But any upward movement in rates still increases their interest rate costs, resulting in a smaller portion of mortgage payments being applied toward the principal, which stretches out the amount of time it takes to repay the loan. For others, an increase in rates also means a larger monthly payment.

On the other hand, opting for a fixed rate right now carries the risk of locking in at a high rate and missing out on possible future rate decreases, Mr. Larock said. In particular, borrowers who sign up with the big banks, which typically apply steep penalties for breaking fixed-rate mortgages, risk “getting stuck behind an iron door,” he said.

Still, variable-mortgage holders must be financially comfortable with the interest rate risk that comes with floating rates, he added.

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