Definition:
A variable rate mortgage (VRM) is a type of home loan where the interest rate fluctuates over time, typically in line with a benchmark interest rate, such as the prime rate or the Bank of Canada’s policy rate. Unlike a fixed-rate mortgage, where the interest rate remains the same throughout the term, the interest rate on a variable rate mortgage can change periodically, resulting in monthly payment variations.

How a variable rate mortgage works

In a variable rate mortgage, the interest rate is tied to a reference rate, which is usually based on market conditions. When the reference rate changes, the lender adjusts the interest rate on the mortgage accordingly. The mortgage payment can either stay the same, with the interest portion fluctuating, or it can change in line with the interest rate adjustment.

There are two main components of a variable rate mortgage:

1. Prime rate or reference rate: This is the benchmark interest rate that the mortgage rate is based on. It is often the central bank’s rate or a commercial bank’s prime lending rate.
2. The spread (or margin): This is the additional percentage added to the reference rate by the lender. For example, if the prime rate is 3% and the spread is 1%, the mortgage interest rate will be 4%.

Types of variable rate mortgages

Variable rate mortgages come in different structures, depending on how the interest rate changes and how payments are adjusted:

• Adjustable-rate mortgage (ARM): The interest rate changes periodically, and the mortgage payment may adjust accordingly. These changes are typically tied to changes in the reference rate.
• Hybrid variable rate mortgage: In this type of mortgage, the interest rate is initially fixed for a set period, such as 3, 5, or 7 years, after which it switches to a variable rate.
• Capped variable rate mortgage: The interest rate is linked to the prime rate but has a cap or limit, which prevents it from rising above a certain level, even if the prime rate increases.

Why choose a variable rate mortgage

A variable rate mortgage can offer several benefits:

• Lower initial interest rates: Typically, the initial interest rate on a VRM is lower than that of a fixed-rate mortgage, potentially resulting in lower monthly payments in the early years of the loan.
• Potential savings when rates fall: If interest rates decrease, the borrower’s mortgage payments could decrease as well, leading to potential savings over the life of the loan.
• Flexible options: Variable rate mortgages often come with flexible terms, such as the ability to make additional payments or pay off the mortgage early without penalties.

Benefits of a variable rate mortgage

There are several advantages to choosing a variable rate mortgage:

• Lower initial payments: The starting interest rate on a VRM is typically lower than that of a fixed-rate mortgage, which can be beneficial in the short term.
• Interest rate flexibility: If interest rates fall, the mortgage rate and monthly payments may decrease as well, providing potential savings for the borrower.
• Long-term savings potential: Over the life of the loan, if interest rates remain stable or decrease, a variable rate mortgage can result in lower overall interest payments compared to a fixed-rate mortgage.
• Prepayment flexibility: Many VRMs allow the borrower to make extra payments toward the principal without penalties, which can help pay down the loan faster and reduce interest costs.

Risks of a variable rate mortgage

While there are benefits, there are also risks associated with variable rate mortgages:

• Interest rate increases: If interest rates rise, the mortgage payments may increase as well, potentially causing financial strain if the borrower is unprepared.
• Uncertainty in payments: The fluctuating nature of a variable rate mortgage means that monthly payments can vary, making it harder for borrowers to budget and plan long-term.
• Payment shock: In the event of a sharp rise in interest rates, borrowers may face a significant increase in their monthly payments, leading to payment shock, which can be financially overwhelming.

How interest rate changes affect a variable rate mortgage

When interest rates change, they directly impact the amount of interest the borrower pays. Here’s how the process works:

• When rates rise: If the reference rate increases, the lender will increase the mortgage interest rate, which could lead to higher monthly payments. If payments remain the same, a larger portion of the payment will go toward paying interest rather than reducing the principal balance.
• When rates fall: If the reference rate decreases, the interest rate on the mortgage will also decrease, which could lower the borrower’s monthly payment. Conversely, the amount of interest paid would also decrease, helping the borrower pay off the loan faster.

Who should consider a variable rate mortgage

A variable rate mortgage might be a good option for certain borrowers:

• Borrowers with short-term plans: If a borrower plans to sell or refinance their home in the near future, they may benefit from the lower initial interest rate of a VRM without worrying too much about interest rate fluctuations.
• Risk-tolerant borrowers: Those who are comfortable with the potential for interest rate increases and who can manage fluctuating payments may find a VRM appealing.
• Borrowers expecting rates to decrease: If a borrower believes that interest rates will stay low or decrease over time, they may benefit from the lower rates of a VRM.

Factors to consider before choosing a variable rate mortgage

Before committing to a variable rate mortgage, consider the following factors:

• Interest rate forecast: Pay attention to the current interest rate environment and economic outlook. If rates are expected to rise in the near future, a fixed-rate mortgage may be a better option.
• Financial stability: Consider whether you have the financial flexibility to absorb possible increases in mortgage payments if interest rates rise.
• Time horizon: If you plan on staying in your home for a long period, a fixed-rate mortgage may provide more certainty and stability. If you plan on selling or refinancing soon, a VRM could be a good option.

Last modified: November 12, 2024