For the past several years both fixed and variable rates have done nothing but fall. With such historically low fixed interest rates (and the spread between fixed and variable being close) I have, until recently, been recommending to my clients that they select the fixed rate option. This changed with the Bank of Canada reducing the Prime lending rate again (two rate reductions in eight months). This indicates to me that the Bank is still concerned about how poorly the Canadian economy is performing. As a result, I feel that the variable rate option will save the most amount of interest and have been recommending it to my clients. However, please understand not all variable rate mortgages are the same!
There are actually two kinds of “variable rate mortgages” – Variable and Adjustable.
1. Variable Rate Mortgage – these are typically offered by the big 5 banks. Here the monthly mortgage payment is set to be a certain amount and never changes even when interest rates move. So if interest rates go up, less of the monthly payment goes to principal and more to interest. If rates go high enough and the required monthly mortgage payment is now entirely interest only, no principal reduction takes place. If rates go even higher, the monthly mortgage payment no longer covers the interest portion. The portion not covered is added back to the mortgage balance – this is known as reverse amortization. This is what happened in the US in 2008. The client was making his mortgage payment but his mortgage balance kept increasing. Eventually the mortgage was worth more than the value of the house with the result the client walked away from the house. Some lenders in Canada even have a “trigger point” which they will trigger if they feel that the house value is not as high as they like compared to the mortgage balance. If this trigger point is reached, the lender then can call the mortgage unless the client can supply an appraisal to confirm the house has a certain value.
2. Adjustable Rate Mortgage – The monthly mortgage payment is set initially based on the rate but if interest rates climb, the portion paid to principal always stays the same. Since the interest component has now increased (with the rate increase) the monthly mortgage payment is also increased. This way the portion going to principal is maintained and the needed interest is paid. No risk of reverse amortization or reaching a trigger point.
Conversion Rates – Both variable and adjustable rate mortgages allow you to convert to a fixed rate mortgage at any time without cost. The key here is to ask what fixed rates the lender will offer you upon conversion. The big 5 have both posted and discounted rates. They will usually offer you something like one percent below posted rate. If you take the time to do the math, you will usually find that this reduced rate is still higher than their discounted rate offered to new clients – nice game. Monoline lenders (non big 5 banks) only have discounted rates and therefore only offer you the same rates they offer their new clients.
So, if you are now considering something other than a fixed rate mortgage, you need to consider the points above and determine which is best for you. Eight times a year I send out a Variable Rate Mortgage Watch to help you decide when the time has come to convert from a variable rate to a fixed rate mortgage. If you have any questions on this discussion or any other mortgage related matters, please feel free contact me and any time!