Shorter fixed-rate mortgages take spotlight as borrowers feel pinch of higher rates

Rapidly rising interest rates have transformed mortgage preferences as borrowers increasingly opt for shorter-term fixed-rate contracts.

The trend is happening as homebuyers look to find a balance between predictability and the ability to respond to hopefully lower rates in the years ahead, say experts.

“People just want stability,” said Victor Tran of Ratesdotca.

It’s a sharp reversal from the variable rates most were opting for at the beginning of last year. But after 10 interest-rate hikes in less than a year and a half, the latest this Wednesday, most are shying away from being vulnerable to more rate hikes.

“Now, everything has changed. I would say, out of 10 clients I’ve signed, maybe one would choose variable,” said Tran.

It’s a trend that started picking up momentum as soon as rates started to rise last year. In January 2022, variable-rate mortgages made up 56.9% of new and renewed mortgages, the Canada Mortgage and Housing Corporation said in a May report.

By January this year, variable-rate mortgages had already fallen to 16.7%, while fixed-rate mortgages with terms of more than one year but less than five years made up a 64% of new and renewed mortgages, showing a continued upward trend.

While five-year terms used to be more popular for fixed-rate mortgages, people are now opting for shorter terms, often three years, in case rates fall, said Tran.

“People feel it’s kind of a sweet spot.”

The shift has come as the rapid rise in interest rates has exposed some of the risks of variable-rate mortgages, said Sherry Cooper, chief economist at Dominion Lending Centres.

Many opted for variable rates as they tended to have more attractive rates and people didn’t expect rates to rise significantly, but now, anyone with a variable-rate mortgage has been under intense pressure as the Bank of Canada’s key policy rate has climbed from 0.25% at the beginning of 2022 to 5% this week as the central bank seeks to quell high inflation.

The current rate of 5% is also a lot higher than the central bank’s rate pre-pandemic, which was at 1.75% heading into March 2020.

People with fixed-rate mortgages who have locked in their rate and monthly payments for up to five years are also under pressure once their contracts come up for renewal. But in the meantime, at least they can prepare for what’s coming, said Cooper.

There are two kinds of variable-rate mortgages, each with their benefits and drawbacks. More popular are fixed-payment deals, where the interest rate fluctuates but the monthly payment doesn’t, said Cooper. As rates rise, a higher and higher share of the monthly payment goes toward interest instead of the capital cost of the home, and as a result the amortization period – the length of time it would take to pay off the mortgage at the current rate – gets stretched.

These kinds of mortgages have not held up well under a rapid succession of rate hikes, said Cooper.

“Variable, fixed-payment borrowers, many of them have hit their trigger point, which meant that their monthly payment wasn’t even covering the interest on their loans, let alone any principal,” said Cooper.

When those mortgages come up for renewal, lenders will likely look to bring the amortization period back closer to the original contract, said Tran, significantly increasing the monthly payments for the mortgage holder.

For anyone who got a mortgage at true rock bottom — the central bank lowered its policy rate to 0.25% in the throes of the pandemic – the shock of this “black swan” tightening cycle has been particularly significant, Cooper said.

“Initially, some people did make lump sum payments to reduce the negative amortization,” she noted, which can help reduce the shock on variable-rate mortgages.

Cooper doesn’t expect a big increase in mortgage defaults, noting that credit card debt is where cracks are really starting to emerge. However, she said there will be more pressure at the edges of the mortgage market too.

But she also sees more people opting for shorter fixed-term contracts. Few are opting for full five-year terms, which peaked in recent popularity in October 2020 at 49% and were languishing at 13% as of January, according to CMHC’s report.

“Fixed rates have become very popular again, and for obvious reasons,” Cooper said. “Yet they’re not going to the full five-year because … people seem to be expecting that interest rates are going to decline fairly soon.”

But rates aren’t likely to go back to recent low levels, said Cooper, and will probably remain elevated in the near term.

“I think that interest rates are not likely to decline until maybe late next year, and maybe not even till 2025,” she said. “Because the Bank of Canada isn’t going to start cutting rates until … we’ve achieved, on a sustainable basis, the 2% target.”

On Wednesday, the Bank of Canada’s Tiff Macklem said the bank doesn’t expect inflation to return to its target until mid-2025.

Mortgage holders and homebuyers are still in the stages of adapting to a major shift in how policymakers and Canadians overall think of interest rates, said Cooper.

“It’s a true sea change in attitude and thinking.”