Variable rate mortgages

If you want to take advantage of a lower initial rate, then consider a variable rate mortgage.

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A variable rate mortgage can save you plenty of money throughout the life of your mortgage. While you won’t have consistent monthly payments, you could pay thousands of dollars less in interest – but that all depends on the prime rate and how it fluctuates throughout the years you carry a mortgage.

Before you decide to apply for a variable rate mortgage, make sure that you understand the risks involved. You’ll also want to be aware of the different types of interest rates available and compare a variety of lenders before you apply for a mortgage.

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What is a variable rate mortgage?

A variable rate mortgage has an interest rate that can change throughout the life of your loan term. Variable rates fluctuate based on the prime rate, which is typically determined by the Bank of Canada’s overnight lending rate. A variable rate is usually expressed as the prime rate + or – a number, with the number being a percentage set by your lender.

While the prime rate can fluctuate based on the economy and other factors, your lender can also technically change the number they charge you – which is what makes a variable rate risky. Rates can rise without much warning, and while variable rates usually start out a fair bit lower than fixed-rates, you could be paying much higher monthly payments a few years into paying your mortgage than you would with a fixed-rate.

For example, if you took out a mortgage of $400,000 at a variable rate of prime (with the prime currently at 3.95%) – 1.34, then you would face an interest rate of 2.61%. But if the prime rate or the number set by your lender changes, your interest rate will change – for better or for worse.

What is a variable rate loan term?

You’ll still choose a loan term for your mortgage, which is usually anywhere from six months to 10 years. This is the amount of time that you will be locked into paying a variable rate with your current lender. Once your loan term matures, you can either refinance with the same lender and stick with your variable rate or you may be able to switch to a fixed-rate, or you could choose to go with an entirely new lender.

Much like fixed-rate mortgages, variable rate mortgages are available with 5-, 10-, 15-, 20-, 25-, 30- and sometimes 35- year amortization periods. They require a down payment of 5-20%. If you put down a downpayment of less than 20%, you will have to pay mortgage insurance, also known as CMHC insurance.

How is variable rate interest calculated?

Variable rates are calculated as the prime rate + or – a number, with the number being set by your lender. As mentioned above, the prime rate can fluctuate based on economic factors, and is typically reflected by the Bank of Canada’s overnight lending rate.

Since both the prime rate and the number that your lender sets can fluctuate, choosing a variable rate comes with risks. Your monthly payments could start out low, but a few years into paying your mortgage, they could increase greatly – which could cause a strain on your monthly budget.

Pros and cons of a variable rate mortgage

Pros

  • Variable rates are usually lower. Variable rates usually start out lower than fixed-rates, which could potentially save you a bundle of money throughout the life of your mortgage. But on the other hand, it could cost you more if the prime rate increases.
  • Convertible and hybrid mortgages are available. You don’t have to stick with a variable rate for the entire life of your mortgage. You can switch once your term matures, or opt for a convertible or hybrid mortgage.

Cons

  • Inconsistent payments. Your repayments can change from month to month, which makes budgeting difficult.
  • Rate increases. The prime rate could increase suddenly, which would ultimately increase your monthly payments and might cause financial strain.

Who is a variable rate mortgage best suited to?

Although this will depend on a myriad of factors and your personal situation, generally variable rate mortgages are good when:

  • The prime rate is low. If the prime rate is low, you can likely secure a lower rate than you would with a fixed-rate mortgage.
  • The economy is stable. If there are talks of the prime rate increasing or any problems in the economy, you might be put off getting a variable rate mortgage.
  • You have good credit. The lender will look at your credit score to determine whether you can commit to your monthly payments over an extended period of time.
  • You have a high income or plenty of savings. Since your monthly payments can fluctuate, you’ll need to make sure you can handle any big jumps in the amount you’ll need to pay toward your mortgage each month.

How does the amortization period of a variable rate mortgage influence interest and equity?

The longer the amortization period of a mortgage, the more interest you’ll pay over the life of the mortgage – but your monthly payments will be lower. Conversely, the shorter the amortization period, the higher your monthly payments will be, but the faster you’ll pay off the mortgage and build equity in your home.

Amortizing your mortgage over 35 years is relatively uncommon. If you don’t put a down payment of at least 20% down on your home, you can’t qualify for an amortization period longer than 25 years.

A 30- or 35- year amortization period may be useful when:

  • You’ve put a down payment of at least 20% on your house.
  • You think you might have an unpredictable income or an unstable job.
  • You want low monthly payments and don’t mind paying more in interest over the life of the mortgage.

A 25- year amortization period is the most common in Canada. Although your monthly payments will be higher than with an amortization period of 30- or 35- years, you’ll pay less interest and be able to own your house sooner.

A 25- year amortization period may be useful when:

  • You plan to retire within the next 30 years or less.
  • You want to own your home relatively quickly.
  • You want to have low monthly payments to free-up your cash flow and live comfortably.

Although your monthly payments will be much higher, especially with a 5- year, 10- year or 15- year amortization period, you’ll pay much less overall interest on the mortgage due to the much shorter time period. You’ll also be able to pay off your mortgage sooner and own your house within a few short years.

A 5- to 20- year amortization period may be useful when:

  • You don’t have a big mortgage to begin with.
  • You don’t have a down payment of 20%.
  • You plan to retire within 20 years or less.
  • You want to own your home quickly.
  • You want to pay less interest.
  • You have a substantial income or low monthly expenses.

What’s the difference between a variable rate and a fixed-rate mortgage?

The primary difference between a variable and a fixed-rate mortgage is that with a fixed-rate mortgage the interest rate remains consistent throughout the loan term, while a variable rate moves up and down in relation to the prime rate.

In addition, lenders generally charge lower initial interest rates for variable rates, while fixed-rates are typically slightly higher to begin with. But over the course of 10 or more years, the opposite could hold true, where the fixed-rate could be lower than the variable rate.

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