A guide to variable and adjustable rate mortgages

When it comes to choosing the right mortgage, understanding your options is crucial. As a mortgage broker, my job is to help my clients navigate the complexities of different mortgage types to find the best fit for their financial situation and goals. In Canada, the primary types of mortgages are variable rate mortgages, adjustable rate mortgages, and fixed rate mortgages. I’m taking a detailed look at the first two of these here. We mortgage pros often use the terms variable and adjustable rate interchangeably. Although they’re very similar, there are a few important differences between them.

The variable rate mortgage in detail

Variable rate mortgages (VRMs) have an interest rate that may change periodically. The rate is usually tied to the prime rate. That in turn fluctuates based on the Bank of Canada’s overnight rate. So usually we express the VRM rate as “prime plus” some percentage or “prime minus” some percentage.

Since VRMs are tied to the prime rate, which changes from time to time, your mortgage rate will change as well. However, if you have a VRM, only the interest rate changes. Your mortgage payment does not change. What is impacted is how much interest you owe, and therefore, how much of your payment get applied to interest and principal. When interest rates decrease, more of your payment goes to principal. If interest rates rise, less of your mortgage payment goes to principal.

The adjustable rate mortgage in detail

Adjustable rate mortgages (ARMs) are similar to VRMs in that the interest rate can change over time. And, as with VRMs, we express the interest rate in connection with the prime rate. The key difference is that when you have an ARM, the payment amount changes whenever the interest changes. Your payment is calculated to cover the interest cost, whatever it is, plus a set amount of principal. The principal amount is based on your amortization, so that you pay off your mortgage in the period of time set at the beginning of your term. The result is that if interest rates rise, your payment will increase, and if interest rates drop your payment will decrease.

How this can help you decide what to do

When I’m discussing mortgage options with my clients, I know they’re often hoping I will say, “the best option for you is to do this.” I wish I could do that! Unfortunately, it’s not as straightforward as either of us would like it to be.

Until the last couple of years, the general thinking was that you were more likely to save money over time by going with an adjustable rate mortgage. This thinking was primarily driven by a 2001 study led by York University Prof Moshe Milevsky. The study showed that in the years 1950 – 2000, going with a floating rate resulted in savings almost 90% of the time. However, it’s important to note that the time frame Milevsky looked at was a lengthy one in which interest rates were generally dropping. When we’re looking at a shorter time frame, such as the 5 year time frame we’re typically dealing with when making a mortgage decision, it is much harder to predict which way interest rates will do. So how do you know what to do?

What I recommend to my mortgage clients

The decision to go variable rate, adjustable rate, or fixed rate is something that you have to decide, and which one is right for you is determined on a case by case basis. So I try to help you make an informed choice by running through a series of questions. These include:

1. Will you be able to sleep at night if you have a fluctuating rate?

Obviously, the unpredictability of rate changes can make budgeting more challenging. But what’s even more important is whether you will be okay with fluctuating rates. If you know you’re a worrier, and will be anxiously checking rates all the time, then you might be better off with a fixed rate. Even if the fixed rate is higher than the fluctuating rates, it’s worth it for the peace of mind you will get.

2. Does your budget allow you to comfortably deal with a higher monthly payment if rates go up?

Obviously, we hope that the opposite will happen, and that rates will drop. If that happens, and you have an adjustable rate, either your mortgage payments will go down, potentially saving you money over the term of the mortgage. With a VRM, a decreasing rate means your payment stays the same, but you’re paying down your mortgage faster. But if rates go up temporarily or even for a prolonged period, can you afford the higher payments? Or with a reduced mortgage principal amount?

3. What specifically are the rates you can get at the present time?

And, therefore, what is the spread between your fixed rate and variable rate options? VRMs and ARMs often start with lower interest rates compared to fixed rate mortgages. But if there is only a small difference between the fixed rate option and the fluctuating rate option, will any benefit to you be quickly wiped out if there is only a 1/4% or 1/2% rate increase? This is especially important to consider if we’re experiencing record low interest rates. The odds of a rate drop may be lower than the odds of a rate increase in that case.

The answers to these questions should help point you in the right direction. Please get in touch if you’d like to chat further about your options!

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