Tax Tip Thursday

Are you a homeowner? If you are, make sure you pay close attention. There are some changes coming!

As you may have heard, they have been forecasting a lot of interest rate hikes in the near future… eight of them, in fact! So, people want to know if this is a good time to lock in the low rates by converting their variable rate mortgages for fixed rate ones. This is a number crunching exercise, but you really want to consider what all the costs are before making a move. Below you’ll find some of the things you need to consider BEFORE even looking at making this conversion.

What’s the difference between the rates?

I consulted some mortgage rates and found that the five-year variable rate offered by one of the big banks starts at 1.60% while the same term fixed rate is 3.04%.

It kind of seems like a no-brainer to go with the variable rate, right? If you borrow $800,000 from the bank with 30-year amortization, going variable could save you $585 per month. That’s a lot of money!

But if you were to refinance the property, the situation can get more complicated. When you refinance to get a bigger mortgage, the bank may only offer you a fixed rate!

On the other hand, if you were to simply convert an existing variable rate mortgage for a fixed rate one just in case the Bank of Canada raises the rate eight times in the next few years, a detailed comparison should be conducted to see whether or not it makes sense.

What’s your plan with the property?

Do you have a short or long term plan with the property?

If you are planning to refinance or sell it soon, be wary of fixed rate mortgages. If you still want to do it anyway, try committing to just one or two years rather than five. The mortgage penalty on a fixed rate mortgage is calculated based on the greater of interest rate differential for the balance of the mortgage or three months’ interest. Unless it is the last year of the mortgage, you are probably paying a lot more than three months of interest!

On the other hand, the penalty on variable rate mortgages is just calculated based on the three months’ interest outstanding. Much easier to forecast, and likely a much smaller amount, as well.

In most cases, fixed penalties will be significantly more money.

Is the mortgage interest and penalty deductible?

If your mortgage is for investments or a rental property, there is an added dimension to the calculations.

If you are breaking a mortgage for the purpose of investment, chances are that the mortgage penalty incurred is tax deductible!

If you are breaking a mortgage of a rental property to pay off your personal mortgage, it can be trickier to get that to be deductible.

Depending on your particular situation, it may or may not be deductible. If it is, the penalty is less expensive than the mortgage penalty that isn’t tax-deductible.

Do not get caught up in the “you can write it off” strategy! Just because you can write it off does not mean that there is no after tax cost.

Still thinking of picking fixed rate? Consider going variable anyway but paying more.

If I were to borrow $800,000 from the bank to purchase a rental property with the following rates available:

1. Variable rate at 1.60% for a monthly payment of $2,797
2. Fixed rate at 3.40% for a monthly payment of $3,382

Obviously the fixed rate is more expensive. Of course, the variable rate could change and end up higher than 3.40%, but that’s a risk you can take. If you don’t like that risk, consider still going with the variable rate mortgage but paying it as though it were fixed rate. Even though you only have to pay $2,797, pay $3,382.  The extra $585 goes straight to pay down the principal! At the end of one year, the principal amount outstanding is lower by $7,000 compared to the fixed rate if interest rates have not changed. By the end of the second year, it would be $14,000!

This way, if interest rates do rise, you’ve paid down some extra principal and are already used to paying the higher amount each month anyway.

Take advantage of the mortgage prepayment amount

Not everyone can qualify for variable rate mortgages. If I ever have to break one, regardless of the rate type, I always try to make a mortgage prepayment so that I can minimize the penalty I would otherwise owe.

As I mentioned above, the mortgage penalty on a fixed rate mortgage can be quite high. The amounts they use are based on the amount outstanding, so the more of it you can pay off in advance, the lower your penalty will be! Even if it means using your home equity line of credit short-term, it could be worth it.

Hopefully rates don’t climb.

Of course, an even better situation would be if the Bank of Canada just didn’t raise the rates. And if they must, it would be nice if they didn’t do it eight times. Sadly, though, things are probably going to get expensive. If you’re looking for some advice or help running these numbers, give us a call or Book an appointment today! We will be happy to help you.

Have an excellent new year!

Disclaimer:

This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal or tax advice nor can it or should it be relied upon. All tax situations are specific to each individual. If you have specific tax questions you should book an appointment for a 1 on 1 consultation.