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What is a Variable Mortgage?

A variable rate, or adjustable rate, mortgage is a type of mortgage that features an interest rate that can fluctuate during the loan's term. With a variable rate mortgage, the rate of interest will change as the market interest rates fluctuate. One type of mortgage does not necessarily exclude the other, because in Canada borrowers can convert their variable rate mortgages into fixed mortgages in a process known as "locking in" a rate.

Benefits of Variable Rate Mortgages

A variable rate mortgage will typically allow for smaller payments. If the market interest rates go down or stay stable during the term of the loan, borrowers may end up paying less interest with a variable rate mortgage than a fixed rate mortgage. When the end of the term arrives, they may find that they have actually paid more toward the principal of the loan and less toward the interest. This may shorten the amount of time required to pay off the mortgage.

Risks of Variable Rate Mortgages

The most common risk associated with variable rate mortgages is rate fluctuation. Assuming the rate remains high, a borrower may pay more interest by the end of the mortgage's term than they would have paid had they selected a fixed rate mortgage option. This also means that by the end of the mortgage's term, they will have paid less on the actual principal of the loan than expected-increasing the amount of time it will take to pay the mortgage off completely. While the risk for an increase in payment is affected by external factors, borrowers can help negate the impact by ensuring they have the extra funds needed to make higher payments.

The risks associated with a variable rate mortgage are dependent on the lender, as well as the terms of the mortgage. Another important risk to be aware of is the fact that payments may increase on a monthly basis if interest rates raise. As such, borrowers should take time to realistically determine how much of an increase in payments they can afford.

Effects on Mortgage Payments when Interest Rates Fluctuate

When there are changes in the interest rates of a mortgage, the outcome will be dependent on the lender as well as the terms of the actual mortgage. The following scenarios are all possibilities of fluctuating mortgage rates:

  1. The monthly payment of the mortgage fluctuates up or down as the interest rates change.
  2. The payment will stay the same when the rates reduce, but will increase as the rates rise. When this scenario is in place, the payment will go toward paying more of the principal when interest rates are down.
  3. The payment only changes when the market rates increase to a predetermined "trigger" point. This will be established in the loan contract. Only when the interest rates reach this point will borrowers be paying higher payments.

Increase in Interest Rate Protection

Many lenders provide a convertibility feature or interest rate cap on their mortgages. These types of features will offer a degree of protection if interest rates rise. These features are only available for those who sign a new mortgage agreement.

The "cap" is the most, or maximum, interest amount that can be charged to a mortgage-no matter the increase in the market interest rates. With these types of mortgages, the payment amount is typically based on the rate of the cap and will end up staying constant for the duration of the term.

A convertibility feature will allow a variable rate mortgage to change into a fixed interest rate mortgage at any point during the term of the loan. In most cases, there will be no charge for this change, however each lender varies, and borrowers should determine their conditions prior to signing their mortgage paperwork.

Important Questions to Consider

When considering a variable interest rate mortgage, there are a number of important questions that should be asked of the lender. Questions include:

  1. "Will your payments change with every interest rate fluctuation, or based on other terms?; How much will payments on my mortgage increase with rises in the interest rate, such as one per cent and two per cent?"
  2. "When an increase in interest occurs, can you opt to increase your payments, as well, to ensure the amount of time it takes to pay off the mortgage remains the same?"
  3. "Will notification be provided if the interest reaches the "trigger" point?"

Being informed about the options that are available for the variable rate mortgage will ensure that an educated decision is made.


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