Most mortgage debates revolve around fixed versus variable rates. But did you know that there are a couple of different types of variable-rate mortgages? There are adjustable and variable rates in Canada, and these terms are often interchangeable. Let’s learn the key differences between these products, so 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 its prime rate. At the end of your term, you will have paid all the accrued interest to the term. Also, your mortgage is paid down at the same pace as the originally 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 downside to this type of mortgage is that it can be tough to budget since your payment can change. All fluctuating mortgages in Canada go through a stress test. Meaning that at the time of approval, you are qualified at the greater of 5.25%, or 2% above the contract rate. This proves that you can afford an increase.
With a variable rate mortgage (often called a VRM), your rate will fluctuate as your lender adjusts their prime rate; however, your payment will not. This means that if the 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 manually increasing your payment with your lender to compensate for the increased interest cost when prime increases. Some lenders also have something called a “trigger rate.” This is the point at which the original mortgage payment no longer covers the interest being changed. In this scenario, lenders allow you a couple of options. They may allow you to increase your monthly payment, make a lump sum payment to cover interest 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?
When entering into a mortgage that will fluctuate with the prime lending rate, the best bet is to understand your option. If your lender increases their prime rate and the options available, 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 when you are in a true variable rate mortgage.
Reach out any time if you’re still unsure which option is best for you!