What is a Variable Rate Mortgage?

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Do you know what is a variable rate mortgage? While it’s true that a variable rate mortgage is the opposite of a fixed rate mortgage, many people don’t realize that there are different types of variable rate mortgages.

Knowing the difference between the two different types of variable rate mortgages is essential since which one you go with will have a direct impact on your monthly carrying costs.

What is a variable rate mortgage?

A viable rate mortgage is when your mortgage payments stay the same, but the interest can fluctuate. So, let’s say your viable rate mortgage is prime -1%. If the prime rate is 6%, then you will be paying 5% interest. However, if that rate goes up to 6.5%, then your interest rate increases to 6.5%. That said, your mortgage payments stay the same, so it just means you have less money going towards the principal of your home and more money paying into interest. However, if the prime rate goes down, then your rate will as well, in which case you will be paying more towards the principal of your mortgage loan and less in interest. 

Variable rate mortgages are generally more flexible than fixed rate mortgages since they require some risk tolerance. Variable rate loans also tend to be offered at a lower interest rate than fixed-rate loans.

What is an adjustable rate mortgage?

An adjustable rate mortgage (ARM) will also be impacted by fluctuating interest rates, however, while payments stay the same with a variable mortgage, your payments will actually increase or decrease with an ARM. 

The potential of having increased regular payments when interest rates are rising may sound like a bad idea, but it can be beneficial. That’s because the amortization period (years of the loan) will not increase. As in, if you have a 25-year amortization period, an ARM will not be affected since it adjusted your monthly payment accordingly.

Variable interest rates only change how much interest you’re paying. However, if interest rates go up, and you’re paying the same amount, that means your amortization period will increase too.

How are interest rates determined

So, if interest rates can increase and decrease so much, how are they determined? Canadian interest rates are determined by a number of factors. These include the demand for loans, inflation rates, interest rates in other countries (especially the USA), and other economic factors.

Bank of Canada

The Bank of Canada’s (BoC) goal with monetary policy is to keep inflation low, stable, and predictable, which helps preserve the value of the Canadian dollar. One of the tools they have to keep inflation in check is their interest rate announcements throughout the year.

When the BoC wants to keep inflation low, they’ll increase interest rates. This encourages people to spend. On the other hand, when they want to stimulate the economy, they’ll lower the rates. With lower rates, people are more likely to borrow and spend more.

Financial institution rates

Once the Bank of Canada sets the overnight rate, individual banks will set their prime rate based on that overnight rate. The prime rate will need to cover the overnight rate plus some to account for the bank’s operating costs. This is why the prime rate you see when you shop for financial products is higher than the overnight rate. After all, the individual banks are clients of the Bank of Canada, and they still need to make money. 

Your individual situation

Another huge variable when determining interest rates is your individual situation. Your credit history, debt load, how much you can afford for a down payment etc., will all impact what interest rate you are offered by the bank or lender when shopping around for a mortgage. Individuals who are in good financial standing with minimal debt and a good credit score will be offered a better rate than those with poor credit scores juggling multiple debts. 

That being said, even if you are in good financial standing, if you only have a small amount to put towards your down payment and need to pay mortgage insurance. If you have variable insurance, this will play a role in increasing that rate. 

What is a trigger rate?

To ensure that homeowners continue to build equity in their homes, banks have what is called a trigger rate in place. A trigger rate is the interest rate level at which the lender is allowed to adjust your payment amount. This would be clearly outlined in your mortgage documents.

Remember, with variable rate mortgages, any increased interest rate changes will make more of your payments go towards your mortgage. If rates keep increasing, your interest payments may exceed your total payments. This would obviously be problematic for lenders, so the trigger rate is sort of a failsafe for them.

How to calculate your trigger rate

Different lenders have different methods of calculating trigger rates, but you can do a rough calculation yourself with the following formula:

(payment amount x number of payments per year/ balance owing) x100= trigger rate %

For example, let’s say your mortgage balance is $500,000 and you make monthly payments of $2,200.

($2,200 x 12/$500,000) x 100= 5.28% trigger rate 

An easier way to figure out your trigger rate is to look at your mortgage documents as it will be listed there. Keep in mind that if you have made prepayments on top of your monthly mortgage payments, then your trigger rate will be increased. If you’re still confused, your best bet is to get in touch with your lender, who can calculate your current trigger rate.

Pros and cons of a variable rate mortgage

Like everything, variable rate mortgages have their pros and cons. So, before you decide, here are a few things to be aware of regarding variable loans.

Variable rate mortgage pros

  • Often more flexible than fixed-rate mortgages.
  • Historically, variable rate mortgages have shown to be advantageous to homeowners.
  • Can usually be converted to a fixed rate mortgage at any time.

Variable rate mortgage cons

  • There’s always a chance that your mortgage rates could go. 
  • Since your payments could go up, there’s never any stability.
  • If you hit your trigger rate, you’ll need to increase your payments.

Variable vs. fixed rate mortgages

As discussed above, with a variable rate mortgage, the payments stay the same, but the interest rate can increase or decrease, which means you might pay more or less towards your principal. A fixed interest rate is, as you guessed by the name, fixed. It doesn’t change during your mortgage term, which can be advantageous if interest rates increase but not so ideal if interest rates decrease.

Fixed interest rates are considered safer options which means they often have higher interest rates and less flexibility than variable interest options. The best choice will depend on your level of comfort and personal financial situation. Learn more about the differences between the two here.

How to get the best variable rate mortgages

As you can see from above, variable rates have their advantages and disadvantages. If you decide that you would like to get a variable rate mortgage, your best bet to get the lowest rate is to shop around. You can do it yourself, or you can use a mortgage broker to do the work for you.

Keep in mind that your individual situation will play a role in the rates you get as well. Creditworthy borrowers get the best deals, so it’s worth your while to make sure that your finances and credit score are in good standing to get a lower rate. 

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About Barry Choi

Barry Choi is a Toronto-based personal finance and travel expert who frequently makes media appearances. His blog Money We Have is one of Canada’s most trusted sources when it comes to money and travel. You can find him on Twitter:@barrychoi

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