Most mortgage debates revolve around fixed versus variable rates. But did you know that there are a couple different types of variable-rate mortgages? In Canada, there are adjustable and variable rates, and these terms are often used interchangeably. Let’s learn about the key differences between these products, so that you can make the best choice for your fluctuating rate mortgage.
With a true adjustable-rate mortgage (often called an ARM), your mortgage payment will increase or decrease, as your mortgage lender adjusts their prime rate. At the end of your term, you will have paid all the accrued interest to the term. You’ll mortgage will alsobe paid down at the same pace as the original projected timeframe. For example, if you had a monthly payment, and entered into a 25-year amortization period, you’d have a 20-year amortization remaining, after your first 5 year adjustable rate term. The only downside to this type of mortgage is that it can be tough to budget since your payment can change. Since all fluctuating mortgages are stress tested in Canada (qualified at the greater of 5.25%, or 2% above the contract rate at the time of approval) you’ve already proven that you can afford an increase.
With a variable rate mortgage (often called an VRM) , your rate will fluctuate as your lender adjusts their prime rate, however your payment will not. This means that if prime increases, a greater percentage of your payment will go towards interest, and less money towards the principal of your mortgage. This means your mortgage balance will be paid down at a slower rate. Inversely, if the prime rate decreases, more of your monthly payment will go toward the principal of your mortgage. To maintain the same amortization schedule, you’re responsible for increasing your payment manually with your lender, to compensate for the increased interest cost in the instance that prime increases. Some lenders also have something called a “trigger rate”. This is the point at which the original mortgage payment is no longer covering the interest that’s being changed. In this scenario lenders would give you the option to increase your monthly payment, make a lump sum payment to cover this interest cost, or convert to a fixed rate. If none of these things happen, then the borrower would have a balance owing at the term end date, which can be an unwelcome surprise.
What to do, what to do?
The best bet when entering into a mortgage that will fluctuate with the prime lending rate, is to be sure you understand what happens if your lender increases their prime rate, and the options available to you to ensure you don’t have any kind of interest cost outstanding at the end of your mortgage term. Also, a good idea to understand how to increase your payment with your mortgage lender, in the instance you are in a true variable rate mortgage.
Reach out any time if you’re still not sure which option is best for you!