What is a Variable-Rate Mortgage (VRM)?
Variable mortgages have gained significant attention in recent years due to many Canadians opting to go variable when interest rates were at all-time lows. Historically, borrowers have opted for variable rates to save money over fixed rates, allowing them to qualify for a larger mortgage or benefit from lower mortgage payments.
There are two types of variable mortgages: variable-rate (VRM) and adjustable-rate (ARM). While both are typically referred to as variable mortgages, this post will provide an in-depth look at VRM mortgages, how they work, how variable mortgage rates in Canada are determined, and when a variable-rate mortgage (VRM) may be the right choice for you.
Key Takeaways
What Is a Variable-Rate Mortgage?
A variable-rate mortgage (VRM) has fixed payments over your mortgage term. However, the interest rate is not fixed and can fluctuate, affecting your principal portion of the mortgage payment.
How it works: When interest rates decrease, more of your mortgage payment will go toward principal and less toward interest. This can help you pay off your mortgage sooner, with the amortization at the end of your term being less than projected at the beginning. This can help you save on interest-carrying costs over the life of your mortgage.
When interest rates increase, more of your mortgage payment will go toward interest and less toward principal. This could mean you reach a point where you are no longer paying anything toward the principal balance. When your payments cover interest only, this can increase the amortization (the time it takes to pay off your mortgage in full) and leave you over-amortized at the end of the term.
If interest rates rise significantly, you could be at risk of hitting your trigger rate or trigger point during the mortgage term. You may be required to bring your mortgage back on track either through a lump sum payment, increasing your mortgage payments, or refinancing to extend your amortization.
Interest rates: Interest rates on VRMs are typically based on the prime rate plus or minus a certain percentage called a discount or premium. For example, if the current prime rate is 6.95% and you have a variable-rate mortgage set at “prime – 0.50%”, your interest rate would be 6.45%. Your discount remains the same throughout the mortgage term, so if the prime rate falls to 6.45%, your new interest rate would be 5.95%.
When to consider: VRMs are often considered by borrowers with a higher risk tolerance, a flexible budget or are comfortable with the potential for the rate to change over their term. VRMs may also be considered when it’s anticipated that rates will decline over the mortgage term, which could result in savings on interest-carrying costs and accelerate the paydown of your mortgage.
Understanding the Prime Rate and Its Impact on Variable-Rate Mortgages in Canada
Interest rates on a VRM are tied to prime rates set by your lender, which are tied to the Bank of Canada policy rate. When the BoC makes monetary policy decisions and raises or lowers rates, lenders will change their prime rates to mirror the changes to the policy rate. Prime rates typically add a spread of 2.20%, making them higher than the policy rate.
How is a Variable Rate Determined?
Lenders base variable rates on their prime rates plus or minus a premium or discount. When you have a variable rate, your discount or premium will remain in place regardless of what changes occur with the prime rate. The difference between the Bank of Canada policy rate and your rate is the cost of funding for your variable mortgage, which your lender charges to lend you the money.
What Determines the Prime Rate?
Lenders set their prime rates based on the Bank of Canada policy rate. The BoC adjusts the policy rate based on global economic conditions, inflation, and the overall health of the Canadian economy.
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The BoC implements monetary policy by influencing short-term interest rates. They adjust the policy rate when needed to stimulate the economy or discourage borrowing and spending to maintain inflation within the target range of 2 to 3%.
How Often Does the Prime Rate Change?
The BoC adjusts the policy rate on 8 fixed dates each year, and lenders will adjust their prime rates accordingly. However, this doesn’t mean that the rate will change at each announcement. During each announcement, the BoC can decide to hold rates steady, increase or decrease them. If rates are held, lenders will maintain their prime rate, but if rates go up or down, lenders will raise or lower their prime rate in line with the changes made to the policy rate.
When the policy rate is increased or decreased, this is done using a unit of measurement called a basis point. For example, if it’s announced that the policy rate will decrease by 25 basis points, this represents a decrease of 0.25%. The BoC can decide to increase or decrease rates by any basis point in 25 increments that it determines is required to preserve the value of the Canadian dollar and keep inflation on target.
Types of Variable Mortgages
There are two types of variable mortgages: adjustable-rate and variable-rate.
Variable-rate mortgages have fixed mortgage payments that remain the same throughout the mortgage term. When interest rates change, the portion of the mortgage payment that goes toward principal and interest changes. If interest rates increase, more of your mortgage payment will go toward interest and less to principal. If interest rates decrease, less of your payment will go toward interest, and more will go toward principal, helping you pay off the mortgage faster.
Adjustable-rate mortgages have adjustable mortgage payments that change if interest rates change. The principal portion of the payment remains fixed while the interest portion adjusts to reflect changes in interest rates. If interest rates increase, your mortgage payment will increase. If interest rates decrease, your mortgage payment will decrease.
Example of Variable-Rate Mortgages
To illustrate how changes in interest rates would affect your mortgage if you opt for a VRM, assume you have a mortgage of $500,000 on a 5-year variable term, 25-year amortization, and were offered a rate of 5.95%. You would pay a monthly mortgage payment of approximately $3,206, with $736 going toward principal and $2,470 going toward interest.
Now, for example, after 6 months, with your interest rate remaining at 5.95%, rates have gone up, and your new interest rate will increase to 6.20% (25 basis points). You would still pay $3,206 per month as your monthly payment; however, you now pay approximately $2,561 in interest, with $645 going toward principal. You are now paying your mortgage principal down slower than you were with your previous interest rate and increasing the time it takes to pay off your mortgage.
Now compare that to what would happen if, after 6 months, your interest rate decreased from 5.95% to 5.45% (50 basis points). You would still pay $3,206 per month; however, you now pay approximately $2,251 in interest, with $955 going toward principal. You are now paying off your mortgage principal faster than your previous interest rate.
Final Thoughts
While variable mortgages are less popular today than a few years ago, they can still offer borrowers cost savings over their next mortgage term if the Bank of Canada continues to decrease rates.
Reach out to nesto’s mortgage experts to learn if a variable mortgage is suitable for your unique needs, risk tolerance and mortgage strategy.
➡️ Ready to secure your mortgage? Contact nesto’s mortgage experts today for the best rates. 📞 1-877-401-5485
💡 This report first appeared on nesto's blog: https://www.nesto.ca/mortgage-basics/what-is-variable-rate-mortgage/