What is a variable rate mortgage?
When you borrow money to purchase a home, the loan is called a mortgage. The percentage of interest the lender charges you to borrow the money is called the mortgage rate.
With a variable rate mortgage, the mortgage payment will remain constant throughout its term, but the interest rate will fluctuate based on market conditions. A good way to think of it is to compare it to a fixed rate. With a fixed rate mortgage, the payment and the interest rate are locked in from the beginning and remain the same for the term of the mortgage. With a variable rate mortgage, the payment is locked in, but the interest rate isn’t.
If you have a variable rate mortgage, the changing interest rates in the market will determine how much of your monthly payment goes to the principal. It’s important to know that if the prime rate increases to a specific percentage or trigger point (listed in your mortgage contract), your lender may increase your payments to ensure you pay off your mortgage by the end of the amortization period.
There will be some months when the interest rates go up and you’ll pay less toward the principal, but there will also be some months when the rates will go down, and a larger portion of your payment goes to paying down the principal.
How is the variable rate determined?
Mortgage lenders base their prime lending interest rates on the Bank of Canada’s prime rate. A variable rate will be quoted as Prime +/- a specified amount, such as Prime - 0.45%. Though the prime lending rate may change, the relationship to prime will stay the same over the term of your mortgage.
When the variable interest rate on a mortgage decreases, a larger portion of your payment goes towards paying off the principal, however, when rates increase, more of the payment goes to interest. Simply put, as the prime rate changes over the term, up or down, the interest rate on your mortgage will change, too.
How often does the prime rate change?
The Bank of Canada sets the target lending rate, which informs mortgage providers’ prime rate. The Bank of Canada may raise or lower their target rate depending on whether the economy is growing or is weak and needs something to stimulate growth. The point is that it’s unpredictable - the prime rate may not change for years, but it can also change several times in a year.
Consider which mortgage rate is right for you
Fixed rate mortgage
Defining features:
- Fixed term and set interest rate
- Same payment for the length of the term
- Protected from rising interest rates
- As you pay down the principal, the amount of interest reduces as well, so more of each subsequent payment is applied to the principal
- Straightforward and easy to understand
Fixed rate mortgages are ideal for you if:
- You think interest rates will increase over time
- You like the idea of having predictable payments
Variable rate mortgage
Defining features:
- Fixed term and changing interest rate
- Same payment for the length of the term
- Can be converted to another term at any time
- Benefit from decreasing rates, but when interest rates rise, more of the payment goes to paying interest rather than the principal
- The variable rate is often lower than the fixed rate.
Variable rate mortgages are ideal for you if you want to take advantage of changing interest rates, but want a fixed payment amount for the entire term of the mortgage.
Can I switch my mortgage from variable rate to a fixed-rate (or vice versa)?
You can change your mortgage rate type at the end of your term when you renew your mortgage. Some lenders also allow you to convert your variable rate to a fixed rate during your initial term. As well, some mortgage lenders offer mortgages that are part fixed rate and part variable rate, so that may be an option as well.
Which kind of mortgage is most popular?
Historically, variable rate mortgages have proven to be less expensive over time. Despite this fact, according to Mortgage Professionals Canada | PDF 2,3Mb,Opens a new website in a new window about 77% of all mortgages are fixed rate, while the remainder are variable rate (18%), or a combination of fixed and variable rate (5%).
Other things to consider when choosing a mortgage:
- The amount of your down payment
- Property taxes
- An open vs. closed mortgage
- Mortgage rate comparisons from bank to bank (or lender)
- Mortgage principal
- Amortization period
- Additional costs to your monthly payment such as title or flood insurance