Understanding Variable Interest Rate Mortgages

What is a variable interest rate mortgage?
A variable interest rate mortgage is a mortgage loan with an interest rate that can change during the term. The interest rate varies with changes in market interest rates (the banks prime lending rate). The mortgage payments can be fixed, or they could change if the interest rate changes - it depends on the lender and the type of product.

What are the benefits of a variable interest rate mortgage?
If market interest rates are stable or go down during your term, you could pay less in interest than with a fixed interest rate mortgage. By the end of your term, it is possible that you could have paid more towards your principle than expected and less towards interest. This would reduce the balance owning and shorten the time needed to pay off your mortgage.

What are the risks?
If the market interest rates go up during your term, your interest rate would increase and you would pay more interest to the lender. As a result, by the end of the term, you might have paid more in interest than if you had chosen a fixed interest rate mortgage. It also means that by the end of your term, you might pay less of the principle than expected. This would lengthen the time needed to pay off your mortgage. Also, depending on your lender and the terms of the variable rate mortgage, another risk is that your payment could increase within your term if the interest rates increase. Consider how much of an increase in mortgage payments you could handle. If you don't think you can handle the risk of your mortgage payment increasing, or do not have enough cash flow, you may be better off with a fixed interest rate mortgage. 

What makes variable interest rate mortgages attractive?
The interest rates on variable rate mortgages are often lower than the fixed interest rate offered at the time you sign the contract. However, whether you are better off with a variable interest rate mortgage, or fixed depends on the movement of the market interest rates (banks prime lending rate) during the term of your mortgage. This movement is difficult to predict. 

What happens to mortgage payments when interest rates change?
When interest rates change, depending on the lender and the terms of your mortgage, the following scenerios are possible; 

1. Your mortgage payment goes up or down each time the market interest rates change.
2. Your payment stays the same when the market interest rates go down, but increases when the market interest rates go up. In this scenerio, more of your payment goes towards paying down the principle when the interest rate falls.
3. Your payment does not change unless market interest rates increase to a "trigger" point (which would be shown in your mortgage agreement). Only at that point will the lender increase your payment.

An example: Sam takes a mortgage with a variable interest rate and the following terms and conditions; The lender explains to Sam that his payments will go up and down with the interest rates. At first Sam's interest rate is stable at 3%. Starting in the second year of his term, market interest rates begin to climb and so do his payments.
  Interest Rate Monthly Payment Interest Paid Principal Paid
Year 1    Initial interest rate: 3.00%  $946 $5, 889 $5, 469
Year 2 rises to 3.5% $997 $6,676 $5, 285
Year 3 rises to 4% $1,046 $7,415 $5,143
Year 4 rises to 4.5% $1,096 $8,106 $5,041
Year 5 rises to 5% $1,144 $8,749 $4, 978
Total - - $36,835 $25,916

In this example interest rate changes happen at the beginning of the year. In this example the interest rate goes up by 2% over the five-year term. Keep in mind that the interest rates could go up or down more or less than 2% over that period, and those changes would of course affect calculations.

Sam's alternative at the time of getting his mortgage was a five-year fixed-rate mortgage. In the example below Sam's lender offered him a fixed-rate of 4% for fives years.
  Interest Rate Monthly Payment Interest Paid Principal Paid
Years 1-5     4% $1,052 $37,230 $25,892

In this example the amount of interest and the amount of principal Sam paid with a fixed or variable rate mortgage would be almost the same. The main difference is that with a variable rate mortgage, Sam's monthly payments would change from year to year, but with a fixed interest rate Sam would know that his payments would stay the same for the full five-year term.

How to protect yourself against a rise in interest rates?
Depending on the lender, some offer interest rate caps or convertibility features on their mortgages. These features can offer some protection if interest rates go up. You can only get these features when you're signing a new mortgage agreement that includes them. A cap is the maximum interst rate that can be charged on a mortgage, regardless of the rise in market interest rates. The convertibility feature on a mortgage allows you to convert to a fixed-rate interest rate mortgage during the term.

What type of questions to ask your mortgage lender?