The following post is by Chris Molder, a mortgage broker with Tridac Corporation Ltd. – The Mortgage Centre in Toronto.
For the past 50 years, variable rate mortgages have been the better option for Canadians, and yet only 13% of borrowers in Canada choose a variable rate over a fixed. What’s up with that?
Perhaps the biggest reason is the inherent risks that come with taking on a variable rate mortgage. While history has proven it’s the better option, it does come with a level of uncertainty that borrowers may shy away from.
To help you understand exactly how a variable rate mortgage works, there are a few things you need to know about them. When you’re done reading this, my hope is you’ll feel a little more confident in your decision to go fixed or variable – no matter which option you choose.
1. The Interest Rate is Based on a Formula
When you are quoted a variable interest rate, it will be based on a formula. The formula is Prime rate plus or minus a certain percentage. For example:
P – 0.25%
For the last three years, Prime has been sitting at 3.00%. If a mortgage broker or lender quoted you this rate today, your rate would be:
3.00% – 0.25% = 2.75%
The thing to remember here is that Prime may change but your relationship to Prime will not change during the term of your mortgage. So if Prime went up to 3.25%, your rate would be:
3.25% – 0.25% = 3.00%
The P – 0.25% is your discount to keep for the duration of your mortgage term. And if you’re currently shopping for a variable rate, remember that the bigger the discount the better. So P – 0.80% is better than P – 0.50%.
2. Changes to Prime = Changes to Your Payment
Now, here’s where a bit of that inherent risk comes into play. What makes a variable rate vary is the fact that it is based on Prime rate. And your lender’s Prime rate is based on the Bank of Canada’s Prime rate.
The Bank of Canada (BoC) meets eight times each calendar year to make monetary policy decisions and decide whether or not they should increase their interest rates. As I said before, Prime rate has sat at 3.00% for three years straight now.
However, if the BoC increased their Prime rate, most lenders would increase their Prime rate by the same amount. For example, if the BoC increased their rate by 0.25%, your lender’s Prime rate would likely also go up by 0.25%. If that happened, the variable rate on your mortgage would become:
3.25% – 0.25% = 3.00%
As Prime rate fluctuates, so do your monthly mortgage payments. On a $300,000 home purchase, that additional 0.25% of interest could cost you an extra $38 per month, $456 per year or $11,350 over the life of a 25-year mortgage.
Since 2007, the BoC’s Prime rate has been as high as 6.25% and as low as 2.25%. While it has remained unchanged at 3.00% for 36 months, there is a chance it could go up again in the future. If you choose to go with a variable rate mortgage, you need to understand this and be prepared for the possibility of your payments increasing.
3. You Can Convert to Fixed
One of the final points to consider when shopping around for a mortgage is finding a variable rate mortgage product that has a conversion feature. By that, I mean the opportunity to go fixed sometime during the term of your mortgage. This is especially important when we are in an upwards rate market (as it’s been said we soon will be), where the Prime rate may go up and locking in at a fixed rate may make you feel more comfortable.
Most lenders will let you convert your variable rate mortgage term to a fixed rate term. However, you need to keep in mind that the fixed rate will likely be higher than your variable rate, causing your payments to increase. And you’ll also be subject to the current rate available on the day you convert, not the day you originally took out your mortgage term.
Armed with these 3 points, you should now understand the most defining features of variable rate mortgage products. To decide whether you should go fixed or variable, you should understand how your monthly payments are affected by both, have some awareness of what’s happening in the Canadian economy and keep these points in mind. And if you have any questions, don’t hesitate to contact me.
This guest post was written by Chris Molder, a Toronto based mortgage broker with Tridac Corporation Ltd. – The Mortgage Centre, located on the Danforth. Chris actively promotes mortgage reduction strategies and tips on his mortgage blog, Son Of A Broker.
You can also find him on Twitter.