How to Save with a Variable Rate Mortgage
When it comes to mortgages, the age-old question remains: “Should I go with a variable or fixed-rate?”. To make an informed decision, it is important to assess your own risk tolerance and budget constraints more than historical trends.
When it comes to variable versus fixed-rate, it is important to first understand their main difference. Fixed rate mortgages are so named as they are based on a fixed interest rate that is set for the duration of the term with fixed payments. On the other hand, variable-rate mortgages fluctuate with the lender's own Prime Rate. This can either mean fluctuations in your payment, or if you choose to have set payments, the interest proportion of each payment.
Next, it is worth knowing that fixed mortgage rates are based off the Canadian bond market, whereas, lenders set their prime rates based off the Bank of Canada overnight rate (currently sitting at 0.25%). This is the rate the Bank of Canada charges lenders. This means that you may see fixed rates change without any corresponding change to variable rates, however, when variable rates change, usually fixed rates follow soon afterwards.
While a variable-rate mortgage is linked to the Prime Rate, which can cause fluctuations, historically the choice of a variable rate mortgage has allowed borrowers to save on their mortgage.
However, due to the uncertainty and potential fluctuations that can occur with a variable-rate mortgage, choosing variable comes down to the borrower's own risk tolerance and comfort levels. Some individuals have no wiggle room in their budget for potential changes in mortgage payments, or they do not like the uncertainty. For these clients, a fixed-rate would be the preferred choice. Also, often the recommendation to first-time homebuyers is to select a fixed-rate as they learn the full costs of homeownership.
On the other hand, clients who qualify for variable-rate mortgages have a unique opportunity to take advantage of lower interest rates. If you have a variable-rate mortgage with fixed payments and if the interest rate drops, it means you are paying more towards your principal each month and vice-versa. Or, if you have flexible payments, you may see your monthly payments drop in accordance to decreases in the Prime Rate.
For my clients who have trouble deciding between a fixed or variable rate mortgage, a strategy I often put to them is to select a variable rate mortgage but make the payments based on the available fixed interest rate. This is assuming they are first fully informed and comfortable with the risks that come with a variable rate.
Let’s look at the following example:
Mya and Cesar take a $500,000 mortgage with a variable rate of 1.25% where the payments are $896 bi-weekly. The mortgage is for a 5-year term and will be paid off completely in 25 years and the payments will fluctuate in accordance to the fluctuations of the lender's prime rate.
When reviewing their mortgage, if they instead set their payments based on the equivalent fixed rate of 2.69% or $1,055 bi-weekly, this will pay an extra $344 on their mortgage each month. At the end of the 5 year term, their savings from paid interest alone is a whopping $33,910. Their outstanding mortgage balance at the end of the term is lower by a whopping $33,745 than if they had selected a fixed rate. By pursuing this strategy, they've also mitigated, to a large extent, the risk of unanticipated, substantial mortgage payment increases impacting their household budget. Furthermore, if they decide their bi-weekly payment of $1,055 is too high, they can always reduce the amount back down to the minimum amount required for the variable rate mortgage.
It is important to note that their total interest savings will decrease if the variable rate rises during the term. However, as long as the variable rate stays below 2.69%, Mya and Cesar will realize a net savings. In fact, even if the variable rate was to rise above 2.69% during the term, it is likely that Mya and Cesar will still have saved money by going with this strategy. The only time Mya and Cesar will not have saved money is if the variable rate rises above 2.69% very early on in the term i.e. during years 1 or 2.
Many of my clients recently have pursued this strategy due to the huge spread between variable and fixed rate mortgages (see below). This gives them more confidence that there is less of a probability of the variable rate rising above the fixed rate in the near term.
Another benefit to variable-rate mortgages is that, if you need to break your mortgage before the term is up, the penalty is typically only three months interest as opposed to much heavier penalties associated with fixed-rate mortgages.
With this strategy you can take advantage of the lower variable rate while, simultaneously, mitigating the risks of unforeseen impacts to your household budget.
Sleep Easy Financial has access to 90+ mortgage lenders including the big banks. We beat the banks’ mortgages and our services are at no cost to you as we get paid by the lenders. Whether it’s for your next home purchase, mortgage renewal or refinance, our licensed mortgage professionals are committed to getting you your lowest rate so you save as much money as possible. We help you at every stage of the journey and are with you for the life of your mortgage. Be mortgage savvy and let us shop your next mortgage for you. Contact us or schedule your complimentary consultation today.
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