What Is Variable Rate Mortgage?

What is a variable rate mortgage?” is a very common question among potential homeowners looking to pay as little as possible with their first mortgage.

Well, variable rate mortgages are loans with a fluctuating rate, which changes along with the prime rates of Canadian banks and shifts in the housing market.

Keep on reading as we explore the topic in detail below!

Variable vs Fixed Rate Mortgages

While most variable-rate mortgages come with fixed payments, their interest rate can still go up and down along with the bank’s prime interest rate. Therefore, when the rate decreases, more of your payment goes to the principal. But, when it increases, a larger portion goes to the interest, extending the time needed to settle the loan fully.

On the other hand, fixed-rate mortgages come with both fixed payments and interest rates, so you’ll know exactly how much you’ll pay by the end.

Despite variable-rate mortgages being proven less expensive throughout history, most consumers still go for fixed-rate loans (77% in 2020) as they prefer budgeting out their entire mortgage and paying it off on time. 

That said, the fixed-rate option still comes with higher initial rates and potential penalties should you break your mortgage. Also, some banks offer capped variable-rate mortgages that limit financial damages with a pre-established rate threshold.

Connection to Canada’s Prime and Overnight Rate

Banks tie their variable rates to Canada’s prime rate—the lowest rate most Canadian banks charge their best and most loyal customers. Furthermore, these prime rates fluctuate along with the Bank of Canada’s overnight rate, which is 2.2% lower.

Therefore, if and when the BoC changes the overnight rate, thus making it more expensive for banks to trade with each other, regular consumers are also affected since banks pass down the increased costs onto the prime rate. Those with variable-rate loans will have to pay rates increased by the same percentage in such cases.

Note: Other factors may also impact a bank’s lending rates, including market changes, lender competition, and demand for different loan products.

Does Variable Rate Mortgage Impact Your Monthly Payment?

In Canada, banks offer two sub-types of variable-rate mortgages: fixed-payment and variable-payment. If you obtain the former, only your interest rates will fluctuate with changes in the prime rate. However, if you get a variable-rate, variable-payment mortgage, both your rate and payment size will change along with the BoC overnight rate.

That said, there are cases in which your monthly payment may also increase even if you have a fixed-payment, variable-rate loan. For example, if the prime rate jumps to such a point that your interest payment increases beyond the total payment amount, banks will have to increase the amount you pay every month to meet this ‘trigger rate’.

Moreover, the current reality is that an increasing number of borrowers are expected to reach their trigger rate because the Bank of Canada has continuously increased the overnight rate since March 2022 to reach an all-time high in the last 15 years.

When Is Variable Rate Mortgage Right for You?

Knowing all of the above, you might be wondering when variable-rate mortgages prove the better choice. Consider the following advantages:

  • Variable-rate mortgages have lower initial rates—to offset the risk of potential hikes in the interest rates, banks offer a discount of up to 1% on their variable-rate loans;
  • You may pay less if the economy is stable or recovering—the overnight rate (and subsequently the prime rate) are increased to curb high inflation rates; however, once these measures start working and inflation starts returning to normal, the loan rates will also decrease—the right conditions to get a variable-rate mortgage;
  • You will have greater payment flexibility—most variable-rate mortgages also allow you to make larger payments or pay off the loan without any penalties;
  • You can still switch to a fixed-rate mortgage—if you believe you won’t be able to handle future rate increases, lenders allow you to switch to a fixed-rate loan;
  • You are able to cover future rate increases—if you are well off and believe you can safely take on the risk of a variable-rate mortgage, it statistically proves the better choice in the long run, provided you can survive periods of rate hikes;
  • You might change homes sooner than expected—taking out a variable-rate loan is also wise if you plan to sell the house before rates increase; in such cases, you’ll simply pay off the remainder of the loan with the proceeds from the sale.

Note: You should consult an experienced financial expert before making any important loan decision, such as the type of mortgage you can apply for and pay in time.

Bottom Line

Variable-rate mortgages are an enticing credit product for most homeowners as they often come with lower interest rates and can prove the better option in times of economic security. Be that as it may, most Canadian consumers still go for fixed-rate mortgages as they want to know exactly how much they owe and how long they’ll be paying off their loan.