An adjustable rate mortgage is one where the mortgage payment amount changes with underlying changes in the interest rate of the mortgage.
How Does an Adjustable Rate Mortgage Work?
An adjustable rate mortgage comes with a floating interest rate, meaning your interest charges may fluctuate over your mortgage term.
Initially, your lender will assign you an interest rate based on prime +/- a certain percentage.
This interest rate may increase or decrease based on a change in the underlying benchmark interest rate.
The prime rate is the benchmark that lenders use as the basis of your adjustable mortgage rate.
Should your lender’s prime rate increase, so will your adjustable mortgage rate and vice versa.
The prime rate itself moves in lockstep with the overnight rate, which is the rate that private lenders charge when lending money to each other.
The Bank of Canada influences the overnight rate by raising or lowering its lending rate (the policy interest rate).
To illustrate how this process works in practice, let’s say the Bank of Canada decides to raise its lending rate to cool down a rapidly expanding economy.
This one rate hike will result in the cost of borrowing rising nationwide, impacting financial institutions and individuals alike.
The overnight rate will increase, thus triggering a corresponding rise in lenders’ prime rate.
The increased borrowing costs will eventually result in an uptick in your adjustable mortgage rate.
Naturally, there’s a level of uncertainty associated with adjustable rate mortgages that could make some borrowers uneasy.
There’s no way to predict how high rates can rise – and if they climb too high, servicing the debt may become impossible.
Some lenders impose caps in adjustable rate mortgage contracts that dictate how often your rate can change and by how much.
These constraints may apply during each rate adjustment period or for your entire loan term.
For example, your lender may include in your contract an agreement that your rate is subject to an adjustment semi-annually and may only increase by 1.25% per adjustment period.
Adjustable rate mortgages are available in various terms and can be open or closed.
Some lenders allow borrowers to convert them to fixed rate mortgages.
Adjustable rate mortgages can be difficult to source as most traditional lenders like banks and credit unions don’t usually offer them.
You’d have to seek out a nonbank lender such as CMLS Financial.
Did You Know?
The Scotia Flex Value mortgage is one of the few adjustable rate mortgages offered by a major bank in Canada.
Benefits of an Adjustable Rate Mortgage
Cheaper Rates
An adjustable rate mortgage offers lower interest rates than a fixed rate mortgage as it poses less risk for lenders.
Potential for Lower Payments
Should the prime rate fall, so will your mortgage rate.
Your regular payment will shrink with lower interest charges, freeing up money you can allocate to other expenses or use to top up your investment accounts.
Pay Off Your Mortgage on Time
With each rate change, your payment size will rise or fall accordingly.
Thus, your amortization period won’t get extended following a rate hike, as your monthly payment will increase rather than remain fixed.
Drawbacks of an Adjustable Rate Mortgage
Potential for Larger Payments
You can expect to pay a higher monthly payment if your mortgage rate increases.
If the increase is substantial and your budget is tight, you may struggle financially and risk missing payments.
Possibly Expensive in the Long Run
If you acquire an adjustable rate mortgage before interest rates rise sharply over a prolonged period, your interest costs could be substantial vs having locked in a higher fixed rate from the get go.
Principal Payment Stays Constant
Should rates drop, your payment amount will decrease rather than a larger portion of it being applied to the principal.
Fact
Adjustable rate mortgages are more prone to delinquency than other mortgages, especially when the economy experiences turmoil. Experts consider them one of the culprits behind the 2008 Financial Crisis.
Adjustable Rate Mortgage vs Variable
A common misconception among homebuyers is that an adjustable rate mortgage is the same as a variable rate mortgage.
However, the two mortgage types differ in how changes in the interest rate impact the payment size.
As mentioned, the rate on an adjustable mortgage fluctuates based on changes in the prime rate.
As the mortgage rate rises, the payment amount increases.
Conversely, as the mortgage rate falls, the payment amount decreases.
With a variable rate mortgage, the contracted interest rate may also change periodically based on movements in the prime rate.
However, the payment amount remains fixed throughout the term regardless of any rate change.
If your mortgage rate increases, your lender will dedicate a larger portion of each payment to interest rather than the principal.
In turn, your amortization period will lengthen.
Alternatively, more of your payment will go toward the principal than interest if rates decline.
As a result, your amortization period will shorten.
Frequently Asked Questions
- How often does an adjustable rate mortgage adjust?
- Does the payment amount of adjustable rate mortgages change?
