Is a Variable-Rate Mortgage Right for You?
Buying a new home is an exciting milestone, but the cost is certainly the issue that most people worry about. A well-chosen mortgage option can save you thousands on interest, but making the wrong decision can cost you thousands more. Since understanding your options is key, you may want to start by looking into the differences between a fixed- and a variable-rate mortgage.
Today, we'll take a closer look at variable-rate mortgages and how they are handled in Canada. We’ll compare it to a fixed-rate mortgage and break down existing pros and cons to help you make an informed decision.
What is a Variable-Rate Mortgage?
There are two main types of home loans in Canada: fixed- and variable-rate mortgages. Unlike a fixed-rate mortgage, a variable-rate mortgage has its interest rate tied to the Bank of Canada's prime rate. This means that when the prime interest rate is low, variable mortgage rates offer significant savings. On the contrary, when prime interest rates rise, this type of mortgage can be more expensive than others. Because of this uncertainty, variable-rate loans typically offer one palpable advantage — a discounted starting rate.
How Do Variable-Rate Mortgages Work?
One could say that a variable interest rate loan is somewhat similar to a fixed-rate mortgage. However, with the variable-rate, if the prime interest rates go up, it can take you longer to repay the principal of your loan and end up costing you more money. Even if you have fixed monthly payments, they could rise as interest rates increase. How? Trigger rates.
The trigger rate is the point at which your mortgage payments are no longer sufficient to cover the interest portion of your loan, requiring an increase in payments to prevent your balance from growing.
Variable Rates Explained
Lenders use the Bank of Canada's prime rate as a benchmark for their own interest rates. That means that variable rates in Canada will typically change based on the Bank of Canada's overnight rate. For a variable interest rate loan, the lender uses the prime interest rate to set your mortgage's initial annual percentage rate. This rate will be detailed in your loan contract but may change at any time if the Bank of Canada's prime rate increases or decreases.
As part of the mortgage approval process, you'll be given a variable rate margin based on your financial situation. The rate margin gets added to the lender's prime rate to calculate your final interest rate — the rate you'll actually pay on your mortgage. That's why you'll often hear lenders say the loan rate is "Prime + 2%," for example. Margin levels depend on your creditworthiness. Borrowers with strong credit often get lower margins, while those with weaker credit may receive higher ones.
How Often Do Variable Rates Change?
There isn't a single factor that determines how many times your interest rate will change. Primarily, it depends on national and global economic market conditions. For example, when inflation is rising, the Bank of Canada will raise interest rates to address the situation. As inflation falls, the prime rate will fall as well. Due to this unpredictability, you need to think twice before opting for this type of loan. If the risk of increased rates exceeds the number of mortgage benefits, you may want to reconsider the option.
Types of Variable Mortgages
If you are new to the world of mortgages, it may be challenging to tell one option from another. That is why we've compiled a detailed comparison table to help you distinguish between different types of mortgage loans:
Type of mortgage | How the payment works | Best for |
Variable payment variable-rate mortgage | The monthly payment will rise or fall depending on the prime rate set by the Bank of Canada | Borrowers comfortable with the fluctuating interest rate, those interested in reaping the most when the primary rate drops |
Fixed payment variable-rate mortgage | The monthly payment stays the same, but when interest rates increase, a larger portion of your payments goes toward paying interest. Falling interest rates mean that more of your money goes toward the principal, so that your mortgage contract can be closed faster. | Borrowers who seek payment stability and do not mind the interest allocation change |
Open variable-rate mortgage | Typically carries higher interest rates but allows you to pay off your loan before the end of the mortgage length | Borrowers planning to sell, refinance, or pay off their mortgage early |
Closed mortgage | The interest rate is usually lower, but if you want to pay off your mortgage before the end of your term, you will have to pay fees and/or penalties | Borrowers interested in lower rates |
As you compare rates, each seems to have obvious advantages and potential drawbacks. However, your individual circumstances and financial stability can help you determine which option would work best for you.
How Do You Determine If a Variable Interest Rate Mortgage Is Right For You?
There are three major aspects to consider if you are comfortable with moving on with a variable interest rate loan:
Budget strength: Consider the possibility of the interest rate going up. Should that happen, will you be able to manage your loan?
Timeline: If you plan to use a variable-rate mortgage as a short-term option, because you may sell the property in 2-3 years, you could benefit from initial lower interest rates. However, it may not work as positively for those who need a long-term loan.
Uncertainty: There's always psychological pressure to factor in. If you know that unpredictability may cause extra stress — reconsider.
This article is only meant to give you a basic idea of whether it is worth choosing a variable-rate mortgage. Please reach out to us for additional professional financial help to ensure you are making the right choice.
Example of a Variable-Rate Mortgage
Imagine having a 4.95% interest rate on a $300,000, 3-year variable-rate mortgage with a 20-year term and choose a fixed-payment structure. This is how things may change depending on the primary interest rate:
Current rate 4.95%
- Payment towards your Principal: $645
- Payment towards your Interest: $1,561
Rate rises to 5.20%
- Payment towards your Principal: $560
- Payment towards your Interest: $1,646
- Effect: paying off the loan more slowly
Rate drops to 4.45%
- Payment towards your Principal: $755
- Payment towards your Interest: $1,451
- Effect: paying off the loan faster
Can I Switch the Type of Mortgage I Have?
Whether you're looking to renew a mortgage or purchase your first home, you might wonder if you can change your mortgage type before the end of your term. Some lenders may allow you to switch to a fixed-rate mortgage during your term, often with a fee or rate adjustment, but switching from fixed to variable typically requires refinancing.
Finding a Mortgage Lender You Can Depend On
It is a lot easier to choose the right mortgage if you have a lender you can trust — one that's supportive, informative, and reliable. Not sure where to start? Use our mortgage selector tool or get in touch with our knowledgeable, supportive mortgage experts to find the best mortgage that suits your needs!
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The Bottom Line
Variable interest rates can be a tricky option to navigate. Whether this type of home loan is the right fit for you depends on your financial situation and your willingness to take on extra risk.
Due to the volatility of prime rates, you should be ready to adjust your budget to varying economic conditions if you choose a variable interest rate mortgage. For further understanding of mortgages and how they work, get a free mortgage transfer eBook to make things easier.