If you’re in the market to apply for a mortgage or are already a homeowner, you may have noticed that mortgage interest rates have been on the rise over recent months, and they’re expected to increase even more.
You may also be aware of the increased costs of goods as a result of inflation. Everything seems to be more expensive including gas, groceries and housing costs.
As inflation increases, so will the cost of your mortgage. Let’s take a closer look at how inflation impacts mortgage costs and what you can do to mitigate these expenses.
How Does Inflation Work?
A low level of inflation can be a good thing for the economy and spur economic growth. But inflation that increases too quickly can do the opposite. When inflation rises too fast, money loses its value and lowers your purchasing power. As a result, consumers tend to tighten their wallets, as their money can’t take them as far as it used to.
Moreover, when inflation increases quickly, businesses raise the prices of goods to keep up with the inflation rates. When this happens, the value of the dollar can plummet. If inflation is not dealt with immediately, a recession can ensue. In some cases, currencies can drop down to zero, rendering them totally worthless.
Will Canada Go Into A Recession?
To prevent this from happening, the Bank of Canada (BoC) has a target inflation rate of 2% per year. This is done by having a target overnight interest rate which determines the borrowing costs between banks over one night. Banks increase their rates when the overnight rate rises to keep their costs low.
Simply put, when prices increase, the Bank of Canada increases its overnight rate, which drives banks to do the same with their rates. In turn, this diminishes consumer borrowing power, causing them to borrow and spend less, which causes businesses to reduce their prices to compete.
The rate of inflation impacts mortgage rates. As mentioned, the prices of goods increase along with inflation rates, which weakens consumers’ purchasing power.
Mortgage lenders typically must maintain interest rates at a certain level so they can still realize a profit when lending money. As such, lenders keep tabs on the inflation rate and will adjust their mortgage rates accordingly.
Having said that, the level of impact of inflation rates on mortgage rates varies depending on the type of mortgage in question; namely, variable-rate versus fixed-rate mortgages.
Variable Mortgage Rates
Variable mortgage rates are expressed as the prime rate plus or minus the bank’s mortgage rate discount. As such, an increase in the inflation rate has a direct effect on variable mortgage rates because of their relationship to the bank’s prime rate.
For instance, let’s say the current prime rate is 6.95%. A variable mortgage rate could be expressed as prime – 1.4% (or 6.95% – 1.4%), which would work out to 5.5%.
But if the Bank of Canada increases the overnight rate by 0.25%, the banks may respond by raising their rates by the same amount. In this case, your variable mortgage rate would inch up to 5.8% (6.95%+0.25% – 1.4%).
Fixed Mortgage Rates
While inflation rates affect fixed mortgage rates, they don’t have a direct impact as they do on variable mortgages. For starters, inflation rate increases or decreases don’t affect those who already have a fixed-rate mortgage. In fact, these individuals, won’t be affected unless they’re due for a mortgage renewal. Similarly, those looking to purchase a property would be affected as their purchasing power will decrease as fixed rates increase.
However, while fixed-rate mortgage rates may increase when inflation rates rise, they are not directly linked to the prime rate. Fixed mortgage rates are more closely tied to bond yields. When these yields rise as a result of an increase in inflation rates, fixed mortgage rates respond accordingly. In this way, inflation rates have a more indirect impact on fixed mortgage rates.
How Does Inflation Cause Mortgage Rates To Go Up?
Using the figures from the above example, the following chart provides a visual of how variable mortgage rates can increase due to inflation after the Bank of Canada increases its overnight rate:
|Prime Rate||Rate Discount||Final Mortgage Rate|
|Original Interest Rate||6.7%||1.4%||5.3%|
|New Rate After Rate Hike||7.2% (6.95% +0.25% BoC point rate increase)||1.4%||5.8%|
Even though the mortgage rate discount remains the same, the Bank of Canada’s increase in its overnight rate will cause the mortgage rate to increase to 5.8 % in this example.
Should You Switch To A Fixed Mortgage?
Your decision to switch to a fixed-rate mortgage comes down to where rates are right now and where they’re expected to be in the near future.
Generally speaking, variable rates are usually a bit lower than fixed rates during the introductory period of the mortgage term. Once this period ends, however, the rate will adjust accordingly to market conditions.
That said, if you currently have a variable-rate mortgage and are considering making a switch, your mortgage rate would have to increase quite a bit over the next few years to make the change worthwhile, considering the relatively large difference between current fixed and variable mortgage rates.
Fixed-rate mortgages are ideal when rates are relatively low, but may soon increase. By locking in a lower rate when you take out a mortgage, you can guarantee that your rate will stay where it is, even if rates start rising afterwards.
This offers stability and predictability with your rate and mortgage payments, helping you budget more effectively. During times of rising inflation — which is the case right now — you won’t have to worry about your mortgage rate increasing throughout the duration of your mortgage term.
At the end of the day, more predictable mortgage payments may be the biggest incentive to make the switch to a fixed-rate mortgage.
Tips On Mitigating The Effects Of Inflation On Your Mortgage
While you may not have any control over what mortgage rates are doing right now, there are a few things you can do to hedge against rising inflation and how it impacts your mortgage. Here are a few helpful tips to consider to protect yourself against increasing mortgage rates:
Make Extra Mortgage Payments
Most mortgages allow borrowers to make extra payments towards the principal portion of their mortgages, up to a certain amount (varies by lender). As rates increase, you may have more incentive now to make an additional mortgage payment to help chip away at your mortgage balance. Plus, this can help you save on the total amount of interest you owe over the life of the loan.
Consider An Early Mortgage Renewal
If you have a fixed-rate mortgage, it might be worth it to renew it before the term ends. Some lenders may allow their clients to sign onto a new term without charging any early renewal fees. It’s possible that the rate you’re charged at the time of renewal may be a bit higher than the rate you originally locked in at, but renewing early could help you avoid even higher rates if you wait longer to renew.
Switch To A Variable-Rate Mortgage
At the time of renewal, consider swapping your fixed-rate mortgage for a variable-rate home loan. This tactic could help you save money if there is a significant gap between the going rates for variable versus fixed mortgage rates.
As mentioned, variable mortgage rates are typically lower than fixed mortgage rates, so there could be savings involved if you make the switch sooner rather than later.
Mortgage And Inflation FAQs
Why do mortgage rates go up with inflation?
Can my lender help me with my mortgage?
Will higher interest rates cool the housing market?
Inflation will certainly have an impact on your housing costs, but there are certain strategies and steps you can take to minimize the effects on your wallet. If you’re able to make additional mortgage payments or switch your mortgage to something that will help you keep costs under control, consider doing so. Otherwise, speak with your mortgage lender to find a solution that works best for you.