How Many Bank of Canada Increases Does It Take to Erase a Variable Discount?

The backdrop

Borrowers choosing at renewal are looking at a gap between fixed and variable that the Bank of Canada may soon close from one side.

According to Canadian Mortgage Trends, Canada’s 5-year government bond yield has risen from roughly 2.6% before the war in Iran began in late February to above 3.6%, topping 3.7% on Monday 28 September. CIBC and TD raised select 3- and 5-year fixed pricing the next day, joining other lenders that had already moved.

Bloomberg, through the same publication, reports the Bank of Canada’s benchmark is currently 2.25%, that overnight swaps put the odds of an increase at the 28 October meeting at about 40%, and that markets are pricing 100 basis points of increases by next September. Headline inflation has hovered near 3% for months, largely on gasoline prices.

The question for someone renewing is whether a variable mortgage priced below the fixed is still the lower-cost choice if those increases arrive.

The setup: one illustrative mortgage

These numbers are hypothetical, not a quote from any lender. Assume a $500,000 balance and a 25-year amortization. Assume a 5-year fixed at 4.95%, and a variable that starts half a point lower at 4.45%.

Canadian fixed mortgages compound semi-annually and variable mortgages compound monthly, and the payments below use each convention. On those assumptions:

• Fixed at 4.95%: about $2,894 a month, locked for the term.
• Variable at 4.45%, no increases: about $2,765 a month. That is roughly $129 less than the fixed.

What each increase does to the payment

Now move the variable up one quarter point at a time, holding the same balance and a payment that is recalculated at each new level. This is a snapshot after the increases have landed, not a forecast of when they would.

• One increase (4.70%): about $2,836 a month, still roughly $58 under the fixed.
• Two increases (4.95%): about $2,908 a month, now about $14 above the fixed. The gap has closed.
• Three increases (5.20%): about $2,982 a month, roughly $88 above.
• Four increases (5.45%): about $3,056 a month, roughly $162 above.

Two things are worth noticing. The half-point discount is gone after two increases, a little before it might seem it should be, because the variable’s monthly compounding is slightly more expensive than the fixed’s semi-annual compounding at the same stated figure. And the damage is not symmetrical in time: every month before the increases arrive, the lower payment is real money that the fixed borrower did not have.

Whether they will happen is the genuinely open part

The experts in Canadian Mortgage Trends’ piece do not agree. Ron Butler of Butler Mortgage says the chance of an increase on 28 October or 9 December is “almost 100%.” Bruno Valko of RMG Mortgages says the decision will likely turn on the consumer price index report due 19 October: stable core inflation could give the Bank room to hold, broader price pressure could strengthen the case to move.

On the other side, TD deputy chief economist Derek Burleton said at an industry event that “the case for hiking is not that compelling,” pointing to core inflation that has been steadier in Canada than in other G7 economies. Dave Larock of Integrated Mortgage Planners called the market’s pricing of five quarter-point increases over the next year “crazy,” arguing that the energy price jump is a supply shock that higher borrowing costs would not reverse.

We covered the same split in our look at the forecasters ahead of 28 October. Nobody quoted here has a record of knowing, and neither do we.

What the arithmetic leaves out

• Whether your variable payment moves. Some variable mortgages hold the payment steady and shift the split between interest and principal, so an increase shows up as slower paydown rather than a bigger payment. Others reset the payment. Which one you have changes how this feels.
• Exit costs. Fixed and variable penalties are calculated differently. See why fixed penalties tend to dwarf variable ones before you assume you can always switch.
• Conversion terms. Many lenders let a variable convert to a fixed during the term, at the then-current fixed pricing, which may not look like today’s. Ask what the terms are before you sign.
• Your tolerance. A payment you can carry at 5.45% is a different decision from one you can carry only at 4.45%.

For a straight renewal with your current lender, the stress test generally does not apply. It does if you switch lenders, which is one more reason to price the whole decision. Our Mortgage Renewal page walks through the options, and the calculators let you run your own balance through both.