What type of variable mortgage should you take?
I keep getting this question over and over again… Keaton what should I do? Fixed rates are too high, variable rates are going to go up like crazy, my renewal is coming up soon and I am worried, what should I do if I want to try to keep my payments the same? Many different questions, one common goal – financial stability and making the right choice.
I personally made the choice for fixed monthly payments that do not change and a variable rate… say what? They make those?
Lets talk about it!
Many Canadians do not know that there are different types of floating rate mortgages.
How do floating rate mortgages work?
Lets set a quick ground rule – I am going to refer to “variable” mortgages as floating rate, I will refer to the two subtypes as variable (VRM) and adjustable rate (ARM). Most people think that all floating rate mortgages are the same and there is quite a bit of confusion around this. At the end of this article you will know the difference and be able to make better decisions for your family.
Both variable rate mortgages (VRM) and adjustable rate mortgages (ARM) offer a discount off of a lenders prime rate (IE Prime minus 0.5%). Lenders prime rates are based on the Bank of Canada’s overnight lending rate. As the Bank of Canada increases or decreases the overnight lending rate banks move their mortgage prime rates in unison a few weeks later.
How do Variable Rate Mortgages (VRM) and Adjustable Rate Mortgages (ARM) work?
Lets take a quick look at your floating rate mortgage options.
Adjustable Rate Mortgages (ARM)
An adjustable rate mortgage has a floating payment. As the prime rate goes up or down your payments will move. The your lender is increasing or decreasing the amount of principal (debt) you pay off every month to keep you on track with your amortization (time until you are mortgage free). Typically when rates rise 0.25% you will see around a $13/m payment increase per $100,000 you owe.
Variable Rate Mortgages (VRM)
A variable rate mortgage has a fixed payment. Every month your payment stays the same even if the prime rate increases or decreases. Lenders are able to offer you fixed payments by increasing or decreasing the amount of debt you pay off each month.
That sounds great, isn’t VRM the better choice everytime?
Another common response I get but sadly its not that simple. Lets look at the cost of these options.
Lets make a comparison. A tale of two borrowers.
Arnie ARM and Victor VRM both buy houses on the same block and each take out a $100,000 mortgage.
Arnie ARM takes an adjustable rate mortgage product and wants to make sure he pays off his debt. Arnie will see his minimum payments increase as the prime rate increases.
Victor VRM chooses a variable rate mortgage instead and prefers to keep his cash flow consistent.
Victor will continue to make the same payment he made his first month.
*I am going to make a few assumptions. I will compare the choices Victor VRM and Arnie ARM make when they choose their mortgage. Each borrowed $100,000 at 2.5% and rates increase 0.25% eight times over 2 years.*
Arnie’s payments started at $395 and reached nearly $506.7 after eight rate increases.
After five years Arnie paid off $9,407 of principal (debt) and $19,584 interest.
Victor’s payments started around $395 and he made this payment for the entire five year team.
After five years Victor only paid off $3,555 of principal and over $20,154 interest.
What does this mean to you?
What does all of this mean? Lets break it down. (Please note this are examples in this scenario and are not predictions of the future. While I am a mortgage broker I do not know your complete situation and you should always seek professional advice before making large financial decisions).
ARM
- Having increasing payments resulted in reducing the interest cost over five years by 3% (roughly $570 per $100,000)
- Paid off almost three times as much debt on the mortgage ($9,400). If rates continued to rise this would have a significant impact long term.
- $29,000 in total payments over five years.
VRM
- Having static payments resulting in an increase cost of borrowing over five years of nearly $570 per $100,000
- Paid down only $3,500 in debt on the mortgage, over 2.5 times less when compared to ARM.
- $23,700 in total payments, around $5,300 less.
But wait… theres more!
While some of you may have decided hypothetically paying 3% more to reduce your total payments by around 18% is the clearly the smart choice other will have decided the complete opposite. Before we rush into any decisions it is critical that we understand what happens after the five year term is over.
At the end of the ARM term things are quite simple, you renew your mortgage choosing a new rate and term. You can choose a fixed rate mortgage or a floating rate mortgage (the options for VRM and ARM vary between lenders and this is why it is a good idea to always talk to your trusted mortgage broker before renewing).
This get a little… err a lot fuzzier at renewal with VRM products.
Variable Rate Mortgages are case by case at renewal
Different lenders have different policies. In this example Victor has fallen quite far behind when it comes to paying his mortgage off over thirty years (amortization).
- Some lenders will adjust the amortization to get everything back on track. In this case Victor’s mortgage would be adjusted at renewal to have a 25 year amortization and his payments would be roughly 6% higher than Arnie’s.
- Other lenders will allow you to stay on your longer amortization or even adjust the amortization back out to the maximum. If Victor’s mortgage paydown was stretched back out to 30 years he would increase his total cost of borrowing nearly 24%! This could mean around a $19,000 increase in borrowing costs over the life of the mortgage (Per $100,000 you borrow!!)
What do Scott and Keaton think this means for you?
Ultimately the choices you make should reflect your personal situation and long term goals.
A few mortgage tips to talk to your mortgage expert about
- Consider a VRM mortgage product to set the lowest minimum monthly payment and using prepayment options to accelerate the mortgage paydown. This can allow you to have a low “minimum” payments while paying off extra principal on a monthly or annual basis. I particularly like this strategy for my clients who have variable pay or seasonal income. Whether you work in the oil industry, are a teacher or work on commission this can be a great way to get ahead on your payments while minimizing your stress. As I am a mortgage broker I chose this option for my family along with a readvancable mortgage so I can access the debt I pay down in emergencies or to invest.
- If cashflow is not a concern ARM is the simpler and easier option. Make your payments, consider your prepayment options with a mortgage broker once a year and off you go!
- If you own rental properties it sometimes makes sense to have an ARM on your residence and a VRM on your investment properties. Instead of making additional payments on the tax deductible debt on your rentals put the money towards the non tax deductible debt on your primary residence. Please seek professional advice before attempting this!
Don’t trigger the bank! Trigger Points
Did you know that with a VRM product there is something called a trigger point? Essentially a trigger point is an imaginary line. If interest rates reach a certain level your lender will make an adjustment to your payments. For some lenders this means a payment increase of a couple dollars, other will adjust your payments to get your amortization to get you back ontrack (this could be a significant jump). I have even heard rumors that some lenders will make a cashcall for all of the missed principal payments. This post is already getting long so I will not attempt to break down each scenario but I want you to know to ask the right questions when making decisions! Often these concerns can be mitigated or eliminated by simply paying extra payments towards your mortgage.
A final word after a long ramble
Its almost over I promise. I want everyone who took the time to read this to understand that now is a time to make informed decisions and to be careful. We have not seen rate increases like we are currently experiencing in a long time. I have spent a fair bit of time calling all levels of banking and lending experts. People who work for the same lenders have given me conflicting answers. I suggest you request these details in writing and you make sure you are working with someone you truly trust to be an expert.
I hope this helped, I have started writing more and if there is anything you would like to see me write about or have any feedback please send me a message!
