Variable mortgage rates are looking increasingly attractive compared to fixed rates, with the potential for significant savings, according to new research from BMO Economics.

With additional Bank of Canada rate cuts expected this year, the bank argues that variable-rate mortgages could offer borrowers more savings over the long run.

“With borrowing costs more likely to fall than rise—and by a lot in a possible trade war—a floating rate mortgage could pay off,” writes senior BMO economist Sal Guatieri.

While current variable mortgage rates are roughly on par with—or slightly higher than—5-year fixed rates, Guatieri notes they’re “unlikely to stay there.”

How variable rates are priced

Unlike fixed mortgage rates, which are influenced by bond yields, variable rates are tied to lenders’ prime lending rates.

These, in turn, follow the Bank of Canada’s overnight policy rate, which currently sits at 3.00%. The current prime rate offered by major lenders is 5.20%, meaning most variable rates are currently priced at a discount off the prime rate.

Most economists expect the Bank of Canada to continue cutting rates this year, in addition to the six consecutive rate cuts the Bank delivered last year. That means lenders’ prime rates should follow suit—bringing down borrowing costs for variable-rate mortgage holders.

Where rates are headed

BMO’s latest forecast sees the Bank of Canada’s policy rate falling to 2.50% by later this year, or potentially down to 1.50% in the event of a full-fledged trade war with the U.S. (See full story here). Under the base-case scenario, this would likely push the prime rate below 4.50%, meaning today’s variable-rate borrowers could see meaningful savings.

Other big banks generally share this outlook, with CIBC, National Bank, and TD all expecting the BoC policy rate to drop to 2.25% by year-end, while RBC is even more aggressive, forecasting a fall to 2.00%.

BoC policy rate forecasts from the Big 6 banks

More borrowers are turning to variable rates

With variable rates looking more appealing, more borrowers are already reconsidering their mortgage options.

Data from the Bank of Canada shows that as of November, nearly a quarter of new mortgages were variable-rate—up from less than 10% earlier in the year.

Mortgage broker Ron Butler told Canadian Mortgage Trends previously that this trend has only accelerated in recent months, noting that the share of variable mortgages he’s originating has jumped from 7% last year to 40% today.

Why BMO thinks it’s a smart bet

BMO argues that with rate cuts ahead, borrowers choosing variable rates today are positioning themselves for lower payments in the near future.

“We estimate a borrower putting 10% down on a half-million-dollar home financed over 25 years would save an average of 40 bps per year compared with locking in for five years,” he wrote. “That equates to just over $100 per month or more than $6,000 in five years.”

In the event that a trade war with the U.S. “torpedoes the economy,” Guatieri says the savings could be even greater, with variable-rate borrowers saving an additional 29 bps on average over the 5-year term—or an extra $74 per month.”

Another benefit, Guatieri notes, is that that variable-rate borrowers still have the flexibility to lock in if rates unexpectedly start to rise.

While there’s always a degree of uncertainty, Guatieri believes the bigger risk is locking into a fixed rate and missing out on potential savings.

Weighing the risks and alternatives

While BMO’s forecast aligns with market expectations for 50 bps in rate cuts this year, Guatieri acknowledges that there’s no guarantee the Bank of Canada will ease further.

“Should the Bank stand pat on rates, locking in could pay off moderately,” he wrote. “Furthermore, the economy could strengthen materially if a trade war is averted, causing inflation to reheat and the Bank to unwind some rate cuts. In this case, a fixed rate would clearly be the better choice.”

For risk-averse borrowers, a shorter-term fixed rate could be a middle ground.

Three-year fixed rates are currently slightly lower than five-year rates and provide the flexibility to refinance sooner at a potentially lower variable rate. According to BMO, this approach could save borrowers about 20 bps per year over five years compared to locking in for the full five years today.

“While that’s still 20 bps higher than opting for a variable rate today, the extra cost may be worth paying to hedge against potential rate increases,” Guatieri added.

This article was written for Canadian Mortgage Trends by: