UNDERSTANDING VARIABLE INTEREST RATE MORTGAGES
What is a variable interest rate mortgage?
A variable interest rate mortgage is a mortgage loan with an interest rate
that can change during the term. The interest rate varies with changes in
market interest rates (the banks prime lending rate). The mortgage payments
can be fixed, or they could change if the interest rate changes - it depends
on the lender and the type of product.
What are the benefits of a variable interest rate mortgage?
If market interest rates are stable or go down during your term, you could
pay less in interest than with a fixed interest rate mortgage. By the end of
your term, it is possible that you could have paid more towards your
principle than expected and less towards interest. This would reduce the
balance owning and shorten the time needed to pay off your mortgage.
What are the risks?
If the market interest rates go up during your term, your interest rate
would increase and you would pay more interest to the lender. As a result,
by the end of the term, you might have paid more in interest than if you had
chosen a fixed interest rate mortgage. It also means that by the end of your
term, you might pay less of the principle than expected. This would lengthen
the time needed to pay off your mortgage. Also, depending on your lender and
the terms of the variable rate mortgage, another risk is that your payment
could increase within your term if the interest rates increase. Consider how
much of an increase in mortgage payments you could handle. If you don't
think you can handle the risk of your mortgage payment increasing, or do not
have enough cash flow, you may be better off with a fixed interest rate
mortgage.
What makes variable interest rate mortgages attractive?
The interest rates on variable rate mortgages are often lower than the fixed
interest rate offered at the time you sign the contract. However, whether
you are better off with a variable interest rate mortgage, or fixed depends
on the movement of the market interest rates (banks prime lending rate)
during the term of your mortgage. This movement is difficult to predict.
What happens to mortgage payments when interest rates change?
When interest rates change, depending on the lender and the terms of your
mortgage, the following scenerios are possible;
1. Your mortgage payment goes up or down each time the
market interest rates change.
2. Your payment stays the same when the market interest
rates go down, but increases when the market interest rates go up. In this
scenerio, more of your payment goes towards paying down the principle when
the interest rate falls.
3. Your payment does not change unless market interest
rates increase to a "trigger" point (which would be shown in your mortgage
agreement). Only at that point will the lender increase your payment.
An example: Sam takes a mortgage with a variable interest rate and the
following terms and conditions;
- Principle amount borrowed: $200,000
- Term (length of the mortgage agreement): 5 years
- Amortization period: 25 years
- Interest rate: variable, initially set at 3%
- Monthly payment: variable
| Interest Rate | Monthly Payment | Interest Paid | Principal Paid | |
| Year 1 | Initial interest rate: 3.00% | $946 | $5, 889 | $5, 469 |
| Year 2 | rises to 3.5% | $997 | $6,676 | $5, 285 |
| Year 3 | rises to 4% | $1,046 | $7,415 | $5,143 |
| Year 4 | rises to 4.5% | $1,096 | $8,106 | $5,041 |
| Year 5 | rises to 5% | $1,144 | $8,749 | $4, 978 |
| Total | - | - | $36,835 | $25,916 |
In this example interest rate changes happen at the beginning of the year. In this example the interest rate goes up by 2% over the five-year term. Keep in mind that the interest rates could go up or down more or less than 2% over that period, and those changes would of course affect calculations.
Sam's alternative at the time of getting his mortgage was a five-year fixed-rate mortgage. In the example below Sam's lender offered him a fixed-rate of 4% for fives years.
| Interest Rate | Monthly Payment | Interest Paid | Principal Paid | |
| Years 1-5 | 4% | $1,052 | $37,230 | $25,892 |
In this example the amount of interest and the amount of principal Sam paid with a fixed or variable rate mortgage would be almost the same. The main difference is that with a variable rate mortgage, Sam's monthly payments would change from year to year, but with a fixed interest rate Sam would know that his payments would stay the same for the full five-year term.
How to protect yourself against a rise in interest rates?Depending on the lender, some offer interest rate caps or convertibility features on their mortgages. These features can offer some protection if interest rates go up. You can only get these features when you're signing a new mortgage agreement that includes them. A cap is the maximum interst rate that can be charged on a mortgage, regardless of the rise in market interest rates. The convertibility feature on a mortgage allows you to convert to a fixed-rate interest rate mortgage during the term.
What type of questions to ask your mortgage lender?- How often could my payments change? Each time the interest rate changes, or on what other basis?
- If the interest rates go up by 1% during the term of my mortgage, how much would my payments increase based on my current mortgage balance?
- If my interest rate increases, can I choose to increase my payments so that the length of time to pay off my mortgage stays the same?
- Are there any conditions under which the payments would stay the same if there was a market interest rates increase?
- Is there a "trigger" interest rate, and how would I be notified of the increase in my mortgage payment?
- Do you offer mortgages with interest rate caps or convertibility features? What are the conditions of using these?
