There’s a lot of talk about interest rates in Canada right now. The Bank of Canada just announced that it won’t be raising interest today. The next announcement is on May 30th, so until then prime rate won’t change. What does that mean for variable rate mortgages?
If you already have one, then you’re probably breathing a sigh of relief right now. If you have a fixed mortgage, then you’ve probably just been watching contentedly from the sidelines, as you know nothing will happen to your mortgage if rates go up.
It is unlikely that rates will go down in the next few years. If you’re getting a variable rate mortgage, then you have to be aware that, at best, your rate will simply not decrease. If the only advantage of a variable rate mortgage was that you could take advantage of dropping rates, then it would be a no brainer to take a fixed rate. But variable rates have other advantages too.
Variable rate mortgages are often priced as prime minus a certain percentage, as they don’t have to update their prices when prime changes.
Right now, the best variable mortgage rate on Rateshop.ca is 2.55%, or prime -0.9. The Bank of Canada usually changes prime rate by 0.25 per cent at a time, whether it’s up or down. The best fixed rate mortgage rate is 3.49%, so for the variable rate mortgage to be more expensive that the fixed rate mortgage, the interest rate would have to increase four separate times. This year, we’ve seen three announcements – once increase and two holds. There are still five more announcements left this year.
Taking advantage of your discount
If you treat a variable rate mortgage as a cheap fixed rate mortgage because you wouldn’t be able to afford a higher fixed rate, if rates rise then you’ll be in trouble. There are ways to take advantage of the discount that can make a variable rate mortgage very attractive.
Many mortgages offer the opportunity to increase your monthly payment by a percentage of your mortgage payment, such as 20% or even 100%. A 100% monthly prepayment options mean doubling your monthly mortgage payments. Any amount that exceeds your normal monthly payment (without going over the limits of what you’re allowed to pay) is applied directly to the principal.
A $300,000 mortgage at 2.55% would have a monthly payment of $1353. The first payment made would pay $638 in interest and $716 to the principal. If your lender allowed a 20% monthly prepayment, you could increase your payments by $271 to $1624. Your principal payment would be $987 instead of $716, which accelerates your repayment without affecting your amortization – in other words, you aren’t required to make a higher monthly payment. With monthly prepayments, you also have the ability to stop, decrease, or increase them (within your limit) as fits your situation month-to-month.
Here’s a graph showing the difference in your remaining mortgage over five years, assuming your interest rate remains the same at 2.55%. At the end of your five year mortgage term, normally you’d have a mortgage balance of $253,425. By paying 20% more per month, at the end of five years your remaining mortgage would be $236,914.80 - $16,510.20 less! You also would have paid $14,880.18 less in interest!
If you had opted for a five year fixed mortgage instead, and paid an additional 20% more, your graph would look like this:
It looks exactly the same, but with a couple important differences.
1. Your monthly payment during this period would have been $1801 - $1501 as per your contract and an additional $300 (20% more).
2. The balance at the end of five years would be $239,865 - $2951 more than the variable.
All Things Being Equal
You might get a mortgage for 2.55%, but before you do you have to qualify with the new mortgage rules. Bad news: that means proving you can afford a mortgage at 5.14%, the Bank of Canada’s posted five-year benchmark as of time of writing.
Good news: if you get approved, that means you definitely can afford to increase your monthly payments. Even if you didn’t ratchet up your payments to the equivalent of 5.14%, you could raise them up to, say, 3.49% - the current lowest fixed rate.
The monthly payments on a 5 year fixed at 3.49% for a $300,000 mortgage is $1501. You can apply the difference between that rate and your rate (in this case, $147) and have the stability of a fixed rate mortgage with the prepayment power of a variable rate.
What if rates go up?
To be fair, my calculations so far haven’t accounted for what happens if your variable rate goes up. The good news is that if you’re paying more than the minimum and rates rise, you can reduce your extra payment to keep your total monthly payment the same. If your lender instead adjusts the proportion of your payment going to interest rather than increasing your payments, then your payments will remain the same (good for your monthly budget, bad for your repayment schedule).
A variable rate mortgage isn’t for everyone. There is a real chance you could end up paying more than a similar fixed rate at the end of a five-year term. However, if you’re the type of person who is comfortable with the risks of a variable mortgage, you can take advantage of big savings!