I was asked the following question from a client and thought others may find this helpful…

Hi Dan,
I have a question I am hoping you can help me with. If you go with a variable rate mortgage and you have the option to lock in, when can I lock in, and is it at the current rate or is there a pre-determined rate you would have to lock into.
For example you indicated a variable rate of Prime – .65 (2.35%) if that was for a 5 year term and you were worried the Bank of Canada is going to increase rates would you be able to lock in at 2.35% for the remaining term or when you lock in you would be locked in at a different rate ie: 2.75% for the remainder of the term.
I am really curious how that works and was not exactly sure.

The benefit of a variable rate mortgage is that at any time during the term, it allows you to lock in to a fixed rate term with no penalty. You usually have to lock in to a term at least matching the remaining term in your variable rate mortgage. ie. If you are in the 3rd year of your 5 yr variable rate mortgage, you have to at least lock in to a fixed term of 2 years.

The problem(or advantage depending on how you see it) with a variable rate mortgage, is that you have a floating rate, based on Bank Prime(today 3%), so prime minus .65% today would give you a rate as you had mentioned of 2.35%. So as prime increase or decrease, so will your rate.
Prime has not changed since 2010, and in most people’s minds is NOT expected to decrease, the most likely possibility is that it will increase, the unknown is WHEN that will begin. Don’t we all wish we had a crystal ball!

As mentioned earlier, if prime were to start to increase, you can at any time lock in to a fixed rate term with that same lender with NO penalty. The catch though is at what rate? There is NO GUARANTEE of any rate until the day you decide to lock in. It is NOT PREDETERMINED. Whatever the lender offers you on that day is the rate you will get. So if you hear on the radio that 5 yr rate went to 4%, and you decide to “chicken out” and lock in, you know you will get at least that rate. So that 2.89% 5 yr fixed rate today that you may have chosen NOT to take when you took a variable rate, is gone. You get whatever rate you get at the time when you lock in.

On a side note, this is why you should NEVER take a variable rate mortgage with any bank. “Banks” have posted rates, ie 5 yr fixed today at 4.85%- check their web site. So when you go to lock in from a variable rate mortgage, which has nothing in writing stating what discount you will get when you lock in, what
rate do you think you will get? Especially when the bank knows you CANNOT leave from a variable rate mortgage, without a 3 month interest penalty! As a broker, I only do variable rate mortgages through lenders that have rates on their sites similar to what you would have been offered if you had taken a fixed rate mortgage in the beginning. ie 2.99% as opposed to 4.79% today(Dec 5th,2014)

The big decision therefore becomes what do I take, variable or fixed. A variable rate at 2.35% today or a 5 yr fixed at 2.89%. There is no right or wrong, as no one today can tell you where rates will be 2 years from today. It is only in the future that you will be able to look back and determine whether or not you made a financially wise decision. A forecast into the future is only that, a forecast with no guarantee.

For those of you who have followed this post for some time now, you know I am a conservative fellow. The rates in general today are at an all-time historical low, with 5 yr fixed being as high as 21% in the early 80’s, 10.3/4% in 1988, to where they are today, 2.89% 5 yr fixed. If you are borrowing a large amount of money to buy a house at the maximum limit of your budget, you probably shouldn’t be taking a variable rate. If you are financially secure with a smaller mortgage and room that if rates go up you can afford the increased payments, then maybe you can afford to take the gamble on a variable rate. Its a personal choice.

Myself personally, I would still choose the fixed rate. I don’t believe the spread between a 5 yr fixed and a variable rate(2.89% -2.35%=.54%) is worth the gamble. I would go with the security of a fixed rate, and payment for the next 5 yrs, but that’s my choice, and I’m sure many of you may choose to differ.

Always remember to see beyond any rate, and ensure that you understand the mortgage you take, and know what it does and does not offer. The fine print is always important.