What are the Different Types of “Variable” Interest Rate Mortgages
Choosing a mortgage type is arguably the most significant financial decision you will have to make after choosing to buy a home. There are two main types of mortgage; A fixed interest rate mortgage and a variable interest rate mortgage. A fixed interest rate mortgage means your lender offers you a rate that stays constant throughout the length of your mortgage term. Most Canadians choose a term of 3 or 5-years duration however there are terms available for as short as 6 months and for as long as 10 years. The interest rate on a fluctuating or variable interest rate mortgage changes whenever the mortgage prime rate changes.
Before we dive into different fluctuating-rate mortgages you may want to brush up on your understanding of the difference between fixed and variable-rate mortgages.
In this article we will cover:
Why interest rates change
The types of variable-rate mortgages
The pro’s and cons of getting a variable rate mortgage
Why Do Interest Rates Change?
A fluctuating-rate mortgage is usually tied to your lenders' mortgage prime rate. The prime rate is heavily influenced by the target overnight rate (or Policy Rate) set by the Bank of Canada (BoC). The objective of changes to the Policy Rate is to preserve the value of the Canadian Dollar by keeping inflation low, stable and predictable within the inflation target of 1 to 3%. This allows Canadians to buy homes and make long-term investment decisions with more confidence. The BoC is owned by the government but its leadership and decisions are independent of the government. Maintaining or boosting the economy is not one of its official objectives but inflation within the target range usually coincides with a healthy level of economic growth. Economic growth is the responsibility of the federal government.
The BoC announces whether or not it will change the Policy Rate at 9 scheduled announcements throughout the year but the BoC may change its rate outside of the schedule if there are extenuating circumstances. At these rate announcements the Bank has three options:
1. Leave rates the unchanged
This is often the case inflation is within the 1 to 3% target which generally coincides with a satisfactory level of economic growth.
Sometimes when most indicators would lead the BoC to raise rates, the uncertainty created by an event (e.g., a trade war, Coronavirus) creates uncertainty and leads the BoC to take a wait-and-see approach.
2. Raise Rates
If the economy is over-heating the bank will often raise rates to increase the cost of borrowing and reduce levels of spending on credit for governments, businesses, and consumers. This cools down economic growth and inflation to a more sustainable level.
3. Lower Rates
This option is used when the Bank fears a serious economic slowdown or the economy is already in recession. Reducing rates means that borrowing money is less expensive and this encourages governments, businesses, and consumers to spend more on credit. This gives the economy a much-needed boost. Essentially, in the short-run, when people borrow to spend money they boost the economy but you can appreciate that there are limits to this solution and long term growth needs to come from government policy and investments in education, infrastructure, and other initiatives that improve Canadian productivity.
With an appreciation of when and why interest rates change, we can now decide whether to choose a fixed interest rate mortgage or a variable interest rate mortgage.
What Variable-Rate Mortgages are Available?
There are three types of variable-rate mortgages. In Canada, we have the option of a Standard Variable-Rate, Capped Variable-Rate, and an Adjustable-Rate mortgage,
Standard Variable-Rate Mortgage (“Standard VRM”)
The Standard VRM involves a fluctuating interest rate with a constant payment during the term. This means that the pace at which you pay down the mortgage principal changes depending on your lenders' mortgage prime rate. The example below illustrates how this might happen.
For Standard VRM’s, the monthly payment should not change unless the monthly interest charged on your mortgage exceeds a “trigger point”. The “trigger point” is typically reached when the monthly interest charged on your mortgage is equal to or higher than the monthly payment agreed to in your mortgage contract. If the trigger point is reached most lenders offer the mortgage holder the following options:
Increase the amount of the monthly payments in order to maintain the pace of mortgage repayment.
Reduce the monthly interest costs by reducing the total amount owing on the mortgage. This is done by making a lump sum payment to reduce the total mortgage until the monthly interest drops below the trigger point.
Convert the mortgage to a Fixed-Rate mortgage with equal monthly payments
Capped Variable-Rate Mortgage (“Capped VRM”)
With a capped variable rate, the rate will fluctuate depending on the market, but the rate will never exceed a threshold established when you take out a mortgage. Other than establishing an upper limit for the interest rate, a Capped VRM behaves the same as a Standard VRM. Like a Standard VRM, you have a consistent payment throughout the mortgage term.
Adjustable-Rate Mortgage (“ARM”)
The primary difference between a VRM and an ARM is that the amount of the regular payment and the pace at which you pay down the mortgage principal.
With a VRM, a rise in the interest rate leaves the regular mortgage payment unchanged but the interest charged rises and the amount of the payment allocated to pay down the principal balance drops and this means it will take longer to pay-off the mortgage. A lower rate has the opposite effect accelerating your pace of mortgage repayment.
With an ARM, a rise in the interest rate results in a rise in the regular mortgage payment to cover the higher interest cost to ensure that the dollar amount allocated to pay down the mortgage principal remains intact. On the flip side, a drop in rates will drop your regular payment without accelerating the pace with which you repay the debt.
An interesting feature of ARMS is that some lenders offer a lower “introductory rate”, for 3 to 6 months, after which the mortgage reverts to the “actual rate” which is the rate you agreed to pay for the remainder of the 3 or 5-year mortgage term. The introductory rate is the “door crasher” rate they show on marketing material to get you to walk in the door. These are often the rates posted on rate comparison sites. Since the actual rate will determine the majority of your borrowing costs over the term of the mortgage, it is essential that you find the best actual rate (or best possible combination of introductory and actual rates) that is available on the market. These “blended rate” calculations can be tricky and that’s why we recommend asking a mortgage broker to do the calculations for you.
Can I change a Fixed-Rate Mortgage to a Variable-Rate?
All lenders will allow you to convert a fixed-rate mortgage to a variable-rate mortgage at the time of renewal (the end of the term). Of course, there are very few restrictions at the end of your mortgage term, you can also switch lenders.
Most lenders will allow you to convert your fluctuating rate mortgage (VRM or ARM) to a fixed-rate mortgage before the term is completed so long as you commit to a longer fixed-rate term than the term remaining on your floating rate term. You benefit from locking in the rate and they benefit by locking you into the borrowing relationship for a longer period of time.
What are the Advantages and Drawbacks of a Fluctuating-Rate Mortgage?
Advantages
Since over the past 30 years interest rates have trended lower, fluctuating rate mortgages have historically led to lower interest costs over the life of a mortgage. It’s uncertain that rates can go any lower than they are today so this historical trend may not hold true in the future.
These mortgages usually have a lower early repayment “pre-payment” fee or penalty.
More often than not, they have a lower initial mortgage interest rate than a fixed-rate mortgage.
Drawbacks
Interest Rates are Unpredictable – if rates rise during your mortgage term then you are going to pay more interest to the lender than you originally expected.
The Bottom Line
When deciding whether or not to take out a fixed or floating-rate mortgage consider your personal situation and the broader economic environment. If interest rates are at a low-point then a fixed-rate mortgage is more likely to result in an overall cheaper outcome. If the economy has been struggling and it seems rates may go down, then a variable rate mortgage is the better option. Your personal situation complicates this decision. If your work regularly transfers people to different cities or you believe you may need to move on short notice for some other reason, then a floating rate option with a lower early repayment “pre-payment” penalty will be beneficial.
Ultimately, it is always best to consult a mortgage broker you can trust. They are professionals for a reason and should give you the best advice for your unique circumstances.
