Variable Rate Mortgage – FAQs

These are home loans where the interest rate is subject to change during the term of the loan. In the same way your line of credit interest rate might change. Variable mortgage rates change in lockstep with changes to the Bank of Canada Prime Rate. For two years since the early days of the pandemic in the Spring of 2020, the Prime Rate was only 2.45%. This resulted in variable mortgage rates between 1% and 1.5%, which is really compelling.

The catch is that variable means just that – the rate may vary and so will the interest you have to pay. And your monthly payment may change too.

As a result, they are not everybody’s cup of tea. Many Canadians prefer the peace of mind and certainty of a fixed rate, fixed payment mortgage loan.

And the proof of that is now, on January 27, 2023 the Prime Rate has already shot up by 4.25% to 6.70%, and variable mortgage rates have gone up accordingly.

We do not have many happy variable rate clients, though there are still some believers who are just willing to ride out this generational event we are experiencing across the globe.

That’s one of the issues. There is no set schedule or time table. At the time of writing this in the Spring of 2020, the Prime Rate had not changed in almost two years since the early days of the pandemic. (March 31 2020 it dropped to 2.45%)

That is pretty fixed and flat!

And prior to the pandemic, the Prime Rate had remained constant at 3.95% for more than two years. (October 2018 to March 2020) But then it dropped three times in three weeks in March of 2020 – each time by 0.5%.

So the changes are not predictable in their frequency or magnitude. And THAT is why many borrowers prefer a fixed rate mortgage.

In fact, today January 27, 2023 we can reflect on the fact there have been several Prime Rate increases since writing the above in the Spring of 2022. And Prime Rate now sits at 6.70% and is now “on pause” while the Bank of Canada does its best to fight inflation with higher rates.

Neither is actually! We’ll only know well after the fact. And even then, who knows? Borrowers with a variable rate mortgage always have the ability to convert to a fixed rate mortgage at any time – so even if rates climb a great deal, many VRM borrowers will jump ship.

In my view, the decision should not be based on your favorite economist’s view of interest rates over the next several years – since no one ever seems to be right about that!

If I sense I am with a conservative who really would not have the stomach for rising rates with a VRM, I nudge them towards fixed. Peace of mind is a very comforting thing.

If they have no strong feelings on the matter, or are looking to us for advice, we would more than likely steer them towards a fixed rate mortgage too. That does not mean we are pessimistic about the outlook for interest rates. It just makes sense not to direct people towards uncertainty if we don’t have a good reason to.

Update: It is now the Fall of 2022 and there are not many arguments in favor of selecting a variable rate mortgage. The actual rate is not much different from a five year fixed rate mortgage AND we expect the variable rate mortgage rates to increase further in the months ahead.

It is more prudent to take a fixed rate mortgage and avoid that unpleasantness. Many of our clients are choosing two and three year term fixed rate mortgages these days.

Update: It is now January 27, 2023 and with Prime at 6.70% every single variable rate mortgage being approved today is higher than any fixed rate equivalent. Only someone needing extreme flexibility or who feels certain they can tell the future (and that it looks rosy) would choose variable today.

Update: It is now December 7, 2022 and with Prime at 6.45% most variable rate mortgages are higher than their fixed rate counterparts. And yet, there is a growing sentiment back towards Variable Rate Mortgages. There is a sense, valid or not no one really knows, that rates will not increase much further, and those with a variable mortgage product are well positioned for the downturn.

Also, we are seeing some clients in cash flow stress choosing to stay the course and NOT switch to fixed. Because it’s the smallest increase to their mortgage payment when they hit their Trigger Rate, not because they are sure it’s right.

Suppose you are in a variable rate mortgage; should you exercise your conversion privilege and change it to a fixed rate mortgage?

The Prime Rate has been so low for so long, many VRM borrowers have forgotten that the “V” in VRM stands for variable! It is understandable to feel nervous… but do not panic!

If you don’t have the stomach for rate increases (you know who you are or you may one day find out) the option to convert your VRM to a fixed rate mortgage any day, any time is there for you.

The catch of course being, you locked yourself in for a five year relationship with your mortgage lender; so you are not going anywhere without incurring a prepayment penalty. This also means there is no incentive for your lender to offer you their absolute lowest, best five year rate at this time. You are not exactly in a power position.

So, whenever I am asked if I prefer variable versus fixed rate mortgages for a client, I usually bring the discussion back to them, not to me. I have never been a fan of predicting interest rates, and look skeptically at those who do.

1. If your mortgage balance is small, relative to your overall finances, why panic? Enjoy the big discount you have over your neighbours’ rates, and get on with your life.
2. If you are risk averse, and want the comfort of knowing exactly what your mortgage payment is going to be for the next five years, then consider the fixed rate approach. Let others worry about rising interest rates.
3. If your finances would become intolerable with rising rates and mortgage payments, this may be another reason to have a locked-in, fixed rate mortgage.
4. Update on December 07 2022. The Prime Rate is no longer so low; sitting at 6.45% and perhaps more increases to come. It certainly does not hurt to ask your mortgage lender what they can offer you if you were to switch to a fixed rate mortgage.
   
   The problem is if you have a static payment variable rate mortgage, your payment will increase FAR MORE if you convert to fixed, than if instead you choose to top up your payment minimally.

Historical data suggests only 25% to 30% of borrowers choose a vrm, but we can tell that in our client base the last couple of years that percentage is more like 50% to 60% have chosen variable. At the time of writing (early 2022) there is lots of talk about rates rising in general. This may result in the percentage of variable rate mortgages going back to historical norms.

Update in the Fall of 2022. In fact, the pendulum has swung the other way and I would guess less than 5% of new mortgages are choosing variable. These are people who are convinced that the rate increases are temporary and want to benefit when they drop back down again. This also includes people who MUST have flexibility and the ability to break their mortgage cheaply, on short notice.

Because the pre payment penalty on a variable rate mortgage is MUCH LOWER than most fixed rate mortgages.

The payments are typically much lower than a fixed rate mortgage. If they are not, you need some other good reason for choosing variable.

Update in the Fall of 2022. This has been true for many years, but not for much longer. There is not much difference now between the variable rate mortgage payments and the fixed rate alternatives.

Update December 7, 2022. Most variable rates are now higher than fixed rates.

The ability to break the mortgage with a relatively small prepayment penalty is attractive. Perhaps you plan to sell in the next few years or you want to keep all your options open – then this can save you lots of money.

You can have your cake and eat it too. Stay below the fixed rate mortgage and at any time you may switch to a fixed rate mortgage if you are no longer feeling secure in the variable mortgage product.

Yes, typically banks and other mortgage lenders will charge a slightly higher rate if the property you are buying or refinancing is an investment property. The range will be mostly 0.1% to 0.25% higher.

Adjustable rate mortgages are a specific type of variable rate mortgage. The mortgage payment is adjusted with each change to the Prime Rate…ensuring that your amortization period and your expected balance owing at the end of your mortgage term does not deviate from your original expectations.

A true variable rate mortgage will vary the rate but hold the payment constant – the result being it helps out borrowers who want to be sure of their monthly payment from one month to the next , but it does mean the expected balance owing at the end of your mortgage term will not be what you thought when you first took the mortgage.

Update in the Fall of 2022. And the problem these days with fixed payment variable rate mortgages is that for many of them, the sharp increase in the Prime Rate means that little of none of the scheduled payments are reducing principal owing on the mortgage. And for some, they are now in what we call “negative amortization”.

When this happens, it means the mortgage has reached its Trigger Rate

The Federal Reserve in the USA and the Bank of Canada are both concerned about inflation. They also remind us the reason rates have been really low this past two years is to protect the economy during the dark days of the pandemic.

In March 2020, the Bank of Canada dropped the Prime Rate three times quickly in chunks of 0.5%, and we went from a Prime Rate of 3.95% to 2.45% in the space of a few weeks.

That was dramatic and swift due to extraordinary generational type circumstances.

The Fed and the BOC will do whatever is necessary to tame inflation. At this point, in the USA talk is they will raise rates four to seven times. Canada does its own thing, to an extent, but can be expected to watch the USA closely and not deviate too much from their approach.

It will mean higher borrowing costs for mortgages but not necessarily bad for the stock market. Morning Brew reports “rising interest rates don’t always spell doom for the stock market. Quite the opposite, in fact.

The S&P 500 has delivered positive returns in 11 of the 12 Fed rate hike cycles since the 1950s, according to Truist co-chief investment officer Keith Lerner. Why? Because the Fed tends to raise interest rates when the economy is growing, and a growing economy tends to be good news for corporate earnings.”

Time will tell, but it feels like the Bank of Canada has given us all a “heads up”about rising rates, and that we will see actual increases commencing the Spring of 2022.

Update on December 7, 2022. Well, rates have risen several times already this year and we are not done yet! After the December 7, 2022 Bank of Canada rate hike, the Prime Rate in Canada now sits at 6.45%.

TD, RBC, BMO, CIBC, HSBC and ICICI Bank offer a mortgage where the payment is set for the term of the mortgage, even if the Prime Rate varies. As we learn of others, we will add them to this list.

Of course, if your variable mortgage payment is static or fixed, this means your amortization period is unknown.

It is possible you could end up in negative amortization territory. This happens when you are only repaying interest and no principal – and in fact if your interest component is bigger than the static payment.

Lenders will likely ask you for a lump sum prepayment if that occurs.

My calculations are such that if you have a 30 year amortization and your payment was set when the variable mortgage rates were 1.35% or less, then you hit negative amortization somewhere when the actual rate of your mortgage is between 4% and 4.5%.

Borrowers with a 25 year amortization are more likely to hit their Trigger Rate when the actual rate of their mortgage is between 4.9% and 5%.

When this happens, it means the mortgage has reached its Trigger Rate

Yes, it will increase if you have the type of variable mortgage where the payment changes every time the Prime Rate Changes. The change is immediate, without delay.

If you have a fixed payment variable rate mortgage (like say from BMO or TD Bank), the amount of interest you will pay to the bank over the term of your mortgage will end up being the exact same as if you had chosen an adjustable rate mortgage where the payments go up and down with each change in the Prime Rate.

If your mortgage funds just prior to the Prime Rate increase, you can preserve the lower payment, but of course if the Prime Rate increases so does the rate on your mortgage – you just won’t be aware of it till the mortgage matures when there is more principal owing than had you started at a higher rate/payment structure.

We do have a few clients doing refinances this month and are trying hard to get done before the next possible Bank of Canada rate increase…in their case, cash flow is crucial.

CTV news quoted our colleague Ron Butler. “A majority of Canadian homeowners with variable-rate mortgages can expect to see an increase in their monthly payments within the month following an interest rate hike by the Bank of Canada, he said.

But the remaining portion – which Butler estimates to be 40 to 45 per cent of Canadians – likely won’t see a change in their payment total, but instead a reduction in the amount of principal being paid. While the mortgage payment stays consistent, Canadians in this situation would be paying more in interest based on increases implemented by the Bank of Canada. This could then impact the amount of time it would take to pay off their mortgage.”

A VRM is priced typically at a discount to the lender’s Prime Rate. It is the discount specifically which is the rate hold.

If the Prime Rate has increased since you were pre approved then yes your pre approval rate changes. It is a VARIABLE rate mortgage after all!

Rates vary without much notice. The pre-approval holds a rate for you which you can discard later if we can do better, but which might prove handy if, in the interim, discounts shrink further than your pre-approval rate. The pre-approval rate hold is a form of rate insurance, and is good for 120 days.

But the amount of money you qualify to borrow will reduce with each rate increase. So if you are relying on a variable rate mortgage pre approval, please ask your mortgage broker to update your borrowing power everytime thee is a change to the Prime Rate.

Here’s is a list of potential reasons you might need to break your mortgage before the end of the term. Although most of our clients take a five year term for their mortgage, you would be surprised how often they break the mortgage before the term is up.

• Job relocation.
• Purchase of a new home.
• Tap into equity from your home.
• Refinance your home to pay off debts.
• Refinance your home to fund a new you love is ill
• Because you lost your job or because you got a new one
• You want to remove or add someone to the title.
• You want to pay off your mortgage before the maturity date.
  
  If you have a variable rate mortgage, it will be far cheaper to break, than if you have a fixed rate mortgage. This is one reason why so many borrowers choose variable – for the flexibility.

On October 26, 2022 the Bank of Canada announced its Overnight Rate has increased by another 0.5% to 3.75%

This means the Bank Prime Rate is now 5.95%; and all Prime related financial products’ interest rates have increased by another half a percent.

If your mortgage has an Adjustable Rate or is a Variable Rate with a static payment, this latest development is yet another day of misery as things just keeping worse.

Borrowers with an adjustable/variable rate mortgage are dealing with a huge increase in payments in nine short months.
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If you had a $500,000 such mortgage with a 30 year am in February of 2022, your monthly payment was just $1,712.59.

Today in late October, 2022 that exact same adjustable rate mortgage has a payment of $2,773.83. An increase of $1,060 in eight short months.
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If you have a static payment, your $1,712 monthly payment is now no longer paying down the mortgage balance.
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You are now in a state of negative amortization. Their $1,712 payment is all going towards interest. In fact, the monthly interest is now $2,041, and your mortgage balance is actually increasing by $329 this month.
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That is the exact opposite of how mortgages are supposed to work.
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So, what can mortgage borrowers who have hit their Trigger Rate do?
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You will find that increasing your payment is likely far easier on your cash flow than converting to a fixed-rate alternative.
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In this example, an increase of $400 should restore your mortgage to one where the balance is declining, whereas converting now handle the larger payment increase, you will be stuck with your variable rate mortgage.