The difference between a variable and an adjustable-rate mortgage

On June 5, the Bank of Canada finally lowered their overnight lending rate by 0.25 per cent, from 5 per cent to 4.75 per cent. This means that most lenders have dropped their prime rate by 0.25 per cent to 6.95 per cent. It has been four years since the Bank of Canada has reduced interest rates.

Crunching the numbers

For every $100,000 on your mortgage, the interest cost will decrease by about $14 per month. This will depend on the rate and amortization period that you have. For lines of credit, the decrease is about $21 per $100,000.

While it is commonly known that there are two types of mortgages — fixed rate and variable rate — most people are not aware that there are two types of mortgages where the interest rate can change depending on the lender’s prime rate. These are known as variable and adjustable-rate mortgages.

The differences between variable and adjustable-rate mortgages

• Adjustable-rate mortgage (ARM or floating rate):

In this case, your mortgage payments will automatically adjust based on your lender’s prime rate to ensure that you maintain your original amortization schedule of your mortgage (the number of years that it will take to pay off your mortgage).

When the Bank of Canada makes any changes to its overnight key lending rate, it affects your lender’s prime rate, which in turn affects the changes in your interest rate.

This means that when the prime rate increases, your mortgage payments increase, and if the prime rate decreases, your mortgage payments will decrease.

• Variable rate mortgage (VRM):

The biggest difference between a variable and an adjustable mortgage is that your payments will remain the same regardless of what happens to your lender’s prime rate during the term of your mortgage.

If the prime rate increases, your payments will not change, yet you will be paying more interest and less principal. If the prime rate decreases, you will be paying more principal and less interest.

However, it is important to be aware that your amortization period maybe longer if interest rates (prime rate) increases or shorter if prime rate decreases.

Commonalities between variable and adjustable-rate mortgages

With both types of mortgages, if you choose to pay out your mortgage early, your penalty will only be a three-month interest penalty.

You can also lock your variable or adjustable mortgage into a fixed rate at any time during the term without paying a penalty. However, you will need to lock into a longer term compared to what your current term is. For example, if you have three years and five months left of your term, you will need to lock into a four year or higher term. If you do choose to lock in, you must be aware that you will be subject to much higher penalties.

What’s ahead

There are four more policy decision meetings before the end of this year. The economists think that we will see at least three more quarter-point cuts this year. The next Bank of Canada announcement is on July 24.

If you are not sure whether to go with a variable/adjustable rate or a fixed rate, talk to a mortgage expert and they will help you find the best option for your individual needs.