Five-year fixed rates are dropping and variable-rate mortgages will soon follow, experts predict

Most fixed-rate mortgages are tied to the five-year bond yield, meaning when the bond yield goes up so does the interest on fixed-rate mortgages. Because the Bank of Canada and U.S. Federal Reserve are holding their respective rates and inflation has lowered, bond yields have fallen as markets begin pricing in the possibility of rate cuts in the first half of 2024. Meanwhile, variable-rate mortgages are tied to the Bank of Canada's rate changes. 

"No one can effectively say where interest rates will be," said Robert McLister, mortgage strategist at Mortgage Logic News. "But as a rough guide we rely on the bond market, and at this moment they expect rate cuts. The markets have priced in five rate cuts in 2024." 

It's important to note when the Bank of Canada decides to cut rates it doesn't cut once or twice, McLister said, it's typically a minimum of four to five cuts amounting to around 225 basis points, based on the average percentage decrease from the peak policy rate.

If the Bank of Canada cuts rates by 225 basis points, variable rates come out "slightly ahead" of fixed-rates, he said. 

"That's enough to give variable rates an edge," McLister said. "But the more the bond market anticipates cuts the more yields fall and the more fixed-rates fall, meaning the less advantage you have with variable on paper." 

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Historically, since the 1950s, variable rates have outperformed five-year fixed rates 75 per cent of the time, he said. However, variable rates are the riskier choice in the off-chance the central banks decides to raise rates again. 

"If your budget is tight, you don't want to float your mortgage rate with little financial backup," McLister added.

But variable rates are making a comeback after falling out of favour since March 2022 when the Bank of Canada began its rapid rate hike campaign.

Ralph Fox, founder of Fox Marin Associates, recently had a client who renewed their mortgage with a variable rate, as Fox expects rates to come down "a little later" but "deeper" than most are expecting, he said. 

"The Bank of Canada will be cautious and they still have some runway with the economy before being forced to cut rates," Fox said. "I could see them cutting rates closer to the summer than spring." 

Once the central bank cuts rates, Fox said, the decreases will be substantial in part due to the bank wanting to avoid a recession. Because people anticipate rates to drop further in the second half of the year, more are willing to opt into a variable rate, meaning they will pay more now, as they believe that by the end of the year they'll have a better rate than the five-year fixed, he added.

Three-year fixed rates are also more attractive right now for homeowners facing renewal who are more risk averse, said GTA-based mortgage broker Mary Sialtsis. 

"I had a lot of clients at the tail end of 2023 moving toward a three-year fixed because in three years the market should have stabilized and interest rates by then could be in the low four per cent to high three per cent range," she said. The three-year fixed offers a compelling alternative to the current five-year fixed which will likely be higher than future rates in a few years time, she added.

"At the end of the day people want to have the lowest rate to give the highest buying budget," Sialtsis said. "And so we see people's buying habits change to fit the current climate."