For some years now, variable rate mortgage loans have become more and more well known and more and more used by borrowers.
A report by Dr. Milevski (York University, Toronto) indicates that between 1950 and 2000, variable rates were cheaper than the 5 by 5 strategy (five years fixed) 88% of the time.
It is clear that this strategy, merely by its variable nature, infers a risk, but over the last years, excellent results have been achieved by assuming this risk.
Description
Interest rates on variable rate mortgages are based on the base rate of the large banks in Canada. The rate a borrower gets is a rabais over this base bank rate. Variable rate loans are always quoted as a base rate less a fixed percentage.
If the base rate, for example, is 6.00%, and the bank quotes “base rate minus .90%”, this means that the variable rate loan will be 5.10% for the length of time that this base rate is in effect. If the base rate is lowered by the Bank of Canada, the loan rate is likewise lowered: a new base rate of 5.25% will mean a variable mortgage rate of 4.35% for that period. The Bank of Canada adjusts this rate 8 times per year. Note that this rate may be refixed at the same rate (no change), so the base rate does not necessarily have to change 8 times a year.
Advantages
- Over time, it is a very good strategy especially if interest rates are stable or decreasing.
- This strategy permits borrowers to take advantage of periods of decreasing interest rates.
- Payments are normally lower.
- This option is offered by a lot of lenders.
Disadvantages
- The rates are variable, so they can go either up or down, adding a risk factor.
- Mortgage payments may change up to 8 times per year, although you can avoid varying rates –see below.
- You have to note when the Bank of Canada is changing its base rate, so you can decide what to do with your home loan.
Over the long term, when should borrowers use this strategy?
The variable rate strategy has been the best choice over time, as studies have shown. This has been the case in falling or stable interest rate environments, but it is important to keep track of interest rate 8 times a year to manage this strategy properly.
Since all of the products that offer a variable rate also offer the possibility of converting to a fixed rate, certain lenders are known (by the mortgage brokers) to raise the fixed rate that they will offer when a borrower is converting.
The explanation for this is simple. Obviously, when a client wants to convert, it is because the interest rates have increased. If the bank has not put any proviso for the conversion rate in the original engagement letter, they can give the client the highest fixed rate, such as the posted rate or the rate with a rabais. This is not the best rate that usually can be secured by a mortgage broker. So the client has to decide which makes more sense over the long run, variable or higher fixed.
Certain lenders (all of the ones we recommend to our clients) promise in the loan engagement letter that when the client makes the choice to convert, he will receive the best broker rate for the loan for that day. You have to carefully choose your lender if you are going to use the variable rate strategy.
Is it possible not to have varying payments?
Many people prefer not to have their mortgage payment change over time, since it makes budgeting difficult. There are ways around this:
You can have your payment fixed, and it doesn’t change even if the rate changes. The amount of your loan that is amortized will change to adjust for this.
You can increase your payments from the beginning so that they are equal to the mortgage payment you would have on a fixed rate mortgage, which is normally higher. In this way, if the rate increases or decreases, your payments will probably remain the same. I prefer this solution.
How does a borrower know when his interest rate will change?
Due to the fact that the rate on your home loan will vary with the base rate, it is important to keep an eye on the base rate. It is not at all difficult to do this.
First of all, the base rate can only change 8 times per year (it’s not that frequent), that is, when the Bank of Canada adjusts it directeur rate. When the bank changes the rate, this information is broadcast throughout the media: newspapers, radio and television).
In addition, we offer to our clients (free of charge) an email subscription service that permits them to follow the change in the base rate each time the Bank of Canada meets. consequently, our clients know the change in the interest rate the same day it occurs, and they also receive predictions for the coming months
A variable rate loan with a ceiling.
It is possible to obtain a mortgage with a variable rate that has a cap on the rate. With this type of loan, if the rate keeps increasing, once the cap rate is hit, it cannot increase any more. The ceiling rate or cap rate on the loan becomes the highest rate your loan can have.
Conclusion
The variable rate strategy is a valuable strategy and should be considered by all borrowers. It can save a borrower thousands of dollars in interest rate costs. But you should follow this advice:
1. Choose a variable loan with a good lender. There are a quite a few of variations with variable rate loans.
2. Pay attention to the conversion option and the rate you will receive at conversion.
3. Make sure you follow the interest rates, or your mortgage broker is going to keep you informed about them.
The variable rate is the strategy which has proved the best option over the last 50 years.
