A variable rate mortgage is a mortgage in which the interest may change periodically during your term.
How Does a Variable Rate Mortgage Work?
A variable rate mortgage is one where the interest rate you pay on the principal may fluctuate.
As a result, the amount you pay in interest during your mortgage term will rise or fall based on how your rate changes.
Your monthly payment size assigned by your lender for your term will always remain the same, regardless of any adjustment to your mortgage rate.
(See Adjustable Rate Mortgage section below for more)
However, each rate shift alters your mortgage’s amortization period.
If your rate increases, a more significant portion of each payment will cover the interest component of your loan rather than the principal.
Thus, your mortgage amortization will get extended, and you’ll incur more interest costs over time.
Conversely, if your rate decreases, a more significant chunk of your payments will get applied against the principal and less towards the interest.
Not surprisingly, your mortgage amortization will shorten, and your overall interest costs will drop.
So how does a variable rate mortgage work in practice?
At the mortgage’s inception, your lender will set an initial interest rate equal to their prime rate plus a markup.
For example, if they provide you with a quote as “prime – 0.50%,” and their prime rate is 3.5%, the variable rate you’ll pay at the beginning of your term will be 3%.
Once your lender finalizes your loan, you’ll begin servicing the debt at your contracted interest rate.
Should your lender’s prime rate change, they’ll adjust your mortgage rate accordingly.
Given the inherent risks posed by rising rates to borrowers, some lenders offer capped variable rates on mortgages.
The capped rate is the maximum rate your lender can charge you during your term, thus limiting your exposure to sharp increases in the prime rate.
What Causes the Prime Rate to Change?
The prime rate is heavily influenced by the Bank of Canada’s (BoC) policy interest rate.
The BoC charges this rate on money that it lends to private banks.
If the BoC decides to raise its policy interest rate, private banks’ borrowing costs rise.
They would then pass on the added expense to their customers by charging higher interest rates on loans.
An upward movement in the prime rate would precipitate a hike in variable mortgage rates.
Did You Know?
The Bank of Canada conducts eight meetings per year to determine its policy interest rate (the interest rate it charges on loans to private banks).
Benefits of a Variable Rate Mortgage
Lower Initial Interest Rate
Variable mortgage rates are usually lower than fixed mortgage rates, making them ideal if your primary concern is to keep your housing expenses as low as possible.
They come with discounted rates compared to their fixed rate counterparts because they’re intrinsically less risky for lenders to issue.
With a fixed-rate mortgage, your lender risks losing out on the extra interest revenue this loan would generate in an environment where rates are steadily rising.
Thus, they assign higher rates to fixed-rate mortgages to offset this risk, no matter the term length.
Pay Off Your Mortgage Sooner
Opting for a variable rate mortgage affords you the possibility of paying your principal sooner than the date noted in your contract.
Should rates decrease, your lender will allocate a more significant portion of each payment you make toward the principal.
The result is a rapidly shrinking mortgage balance and savings in interest costs.
Cheaper Prepayment Penalty
Prepayment penalties are less stringent if you break a variable rate mortgage than a fixed-rate mortgage.
With a variable rate, your lender calculates your penalty as the equivalent of three months worth of interest payments.
On the other hand, if you hold a fixed-rate mortgage, your lender performs two calculations: three months’ interest and the interest rate differential (IRD).
Then, they assess the penalty using the higher figure.
If the formula favours the IRD, you could face a much heftier penalty than you would if you paid only the equivalent of three months’ interest.
You can convert a variable rate mortgage to a fixed rate mortgage but not the other way around.
Drawbacks of a Variable Rate Mortgage
Potentially More Expensive
A variable rate mortgage leaves you vulnerable to rate hikes.
You’ll pay considerably more in interest if rates spike during your term, and your amortization period will lengthen.
If rates climb high enough, your amortization may turn negative, leaving your monthly payment insufficient to cover your interest.
In this rare instance, your lender may increase your monthly payment size to ensure it’s large enough to settle the accrued interest.
Not as Beneficial if Rates are Already Low
If general interest rates across the economy have already dropped to near zero, there is little benefit left from changes in the prime rate, as it’s doubtful that rates will drop any further.
In this case, opting for a fixed rate mortgage may make more financial sense since rates have nowhere to go but up.
This is scenario specific and can differ in a rising rate environment vs one where interest rates will stay near zero for many years.
Variable Rate Mortgage vs Adjustable Rate Mortgage
A common misconception among homebuyers is that a variable rate mortgage is identical to an adjustable rate mortgage (ARM).
However, there’s a crucial difference between these two loans products.
A key characteristic of a variable rate mortgage is that your monthly payment remains the same throughout your term, regardless of any fluctuations in your interest rate.
The only aspect that changes is the percentage of each payment applied to the principal.
With an ARM, your interest rate is also subject to change based on your lender’s prime rate shifts.
However, in stark contrast to a variable rate mortgage, your payment size will also change, depending on how the prime rate moves.
Thus, if your ARM mortgage payments are currently $825 per month, you could pay $900 should your rate rise and $750 if it falls.
With a variable rate mortgage, your payments would always be $825.
With ARMs, if the prime rates rise, you could get stuck with a potentially steep monthly payment, which can strain your budget.
Adjustable Rate Mortgages are typically issued by B lenders.
Frequently Asked Questions
- Do payments change on variable rate mortgages?
No, your payments remain the same on a variable rate mortgage, regardless of the interest rate you pay for the duration of your term.
- Why would you get a variable rate mortgage?
A homeowner may choose a variable rate mortgage over a fixed rate mortgage because the former is cheaper.
Since the variable rate on a mortgage moves in tandem with the prime rate, you could also realize more savings in interest if the latter drops during your term.
A variable rate mortgage also has a cheaper prepayment penalty, so if you think you may need to pay out your mortgage before the term ends, a VRM can offer peace of mind (3 months’ interest fee to break).