Understanding Variable Rate Mortgages

With the Bank Of Canada announcing the second rate cut this year and the banks quickly following with a partial reduction in their prime lending rates, more Canadians are looking to take advantage of these low rates and considering a Variable Rate Mortgage.      

What is a Variable Rate Mortgage?

In comparison to a Fixed Rate Mortgage in which the interest rate and payments are set at the time of origination and remain the same for the entire life or term of the loan, with a Variable Rate Mortgage the interest and payments can fluctuate over time depending on the lender’s prime interest rate. Variable Rate Mortgages (VRM) currently offer a discount off of prime. The majority of lenders available through Mortgage Brokers are currently offering a VRM at Prime - .65 on a full featured mortgage. With lenders reducing Prime now to 2.70, this means you can enjoy a mortgage with a rate of 2.05%. Full features include prepayment privileges allowing you to increase payments by 15-20% as well as lump sum payments annually of 15-20% of the balance (depending on lenders’ features). If you were to pay off your mortgage early you would only incur a three month interest penalty. Mortgage Brokers also have access to lenders offering Variable Rate Mortgages with a deeper discount off prime but come at the cost of reduced prepayment privileges, higher penalty costs based on a percentage of the mortgage balance if you were to pay off your mortgage before maturity, or can only be paid off with a sale of the property. While a lower rate can make a mortgage more affordable with lower payments, lenders qualify borrowers at a higher benchmark rate (currently 4.64%) which ensures the borrower can risk a fluctuation in rates and increase in payments. Taking advantage of today’s best rates in a Variable Rate Mortgage by setting your payments at a higher amount will quickly see you reducing your mortgage balance. With a lower interest rate, more money is applied to reducing your principle balance.  

VRM vs. Fixed Rate Mortgage

Let’s compare a $300,000 mortgage on a Variable, Fixed and Variable with Increased Payments to match the fixed rate payments  

$300,000 Mortgage 5 year term, 25 year amortization	Payment	Balance at end of  Year 1	Balance at end of Year 2	Balance at end of Year 3	Balance at end of Year 4	Balance at end of Year 5
VRM at 2.05%	$1,277.60	$290,706.00	$281,220.00	$271,539.00	$261,659.00	$251,575.00
Fixed Rate Mortgage at 2.59%	$1,357.38	$291,338.00	$282,450.00	$273,330.00	$263,973.00	$254,372.00
VRM at 2.05% with payment same as fixed	$1,357.38	$289,739.00	$279,267.00	$268,580.00	$257,672.00	$246,540.00

    Although the above chart is based on NO CHANGE happening over the next 5 years with prime rates as we cannot predict when and if the variable rate mortgage may increase (or decrease like we have recently seen) in fact we have seen rather stable prime rates over the past 5 years no higher than 3%. You can clearly see the impact it can have on your mortgage. Even at the end of year two assuming rates do not change by paying the same payment as a fixed mortgage you have already reduced your mortgage balance by $3,183 more! The above scenario is also based on monthly payments, weekly or biweekly payments can also have an impact to further decrease your balance. The risk with a Variable Rate Mortgage is WHEN and IF and HOW MUCH a prime rate increases which could result in a higher interest rate and payment. Talk to a Mortgage Broker at The Mortgage Advisors today to review your options.