Buying a new home is an exciting milestone. And one of the most important choices you can make during the home buying process is selecting a mortgage that fits your needs. Understanding your options is key, and a great starting point is deciding between a fixed and variable-rate mortgage.
Let's take a closer look at variable-rate mortgages in Canada. We'll compare them to fixed-rate mortgages and break down their pros and cons to help you make an informed decision.
What is a Variable-Rate Mortgage?
When it comes to interest rates on your home loan, you have two chief options — fixed and variable-rate mortgages.
Variable-rate mortgages have their interest rates tied to the Bank of Canada’s prime interest rate. When the prime interest rate is low, variable rates offer significant savings. However, when prime interest rates rise, a variable-rate mortgage can be more expensive than other types of mortgages.
It’s because of this uncertainty that variable-rate mortgages typically offer a discounted starting rate, and why this mortgage type suits borrowers with a higher risk tolerance.
How Do Variable-Rate Mortgages Work?
In the big picture, a variable-rate mortgage is somewhat similar to a fixed-rate mortgage. However, there are a few key differences. If the prime interest rates go up, it can take you longer to repay the principal of your loan and end up costing you more money. Even if you have fixed payments, your monthly payment could rise as interest rates increase.
If those rates reach the "trigger rate," you may need to adjust your mortgage payments to stay on track. The trigger rate is the point at which your mortgage payments are no longer sufficient to cover the interest portion of your loan, requiring an increase in payments to prevent your balance from growing.
Variable Rates Explained
What factors define a variable interest rate? Let’s start by exploring its structure.
Lenders use the Bank of Canada’s prime rate as a benchmark to determine their prime interest rate. That means that variable rates in Canada will typically change based on the Bank of Canada’s overnight rate. For a variable-rate loan, the lender will look at the prime interest rate to set your mortgage’s starting interest rate. This rate will be detailed in your loan contract but may change at any time if the Bank of Canada’s prime rate should increase or decrease.
As part of the mortgage approval process, you'll be given a variable rate margin based on your financial situation. The rate margin gets added to the lender’s prime rate to calculate your final interest rate—the rate you'll actually pay on your mortgage. That’s why you’ll often hear lenders say the loan rate is “Prime + 2%”, for example.
It’s important to note that margin levels depend on your creditworthiness. Borrowers with strong credit are usually assigned lower margins, while those with weaker credit may receive higher ones.
How Often Do Variable Rates Change
It’s difficult to predict how often rates could change over the course of your mortgage term. The primary driver of variable interest rate changes in Canada is the Bank of Canada’s prime rate, which is influenced by national and global economic conditions. For example, when inflation is on the rise, the Bank of Canada will increase interest rates to remedy the situation. As inflation falls, so will the prime rate.
You will need to decide if the risk of rates increasing is worth the possible benefit of lower overall loan costs. A trusted mortgage advisor can also help.
Types of Variable Mortgages
Here are the different approaches to classifying the types of variable-rate home loans:
Variable Payment Variable-Rate Mortgage. Payments will increase or decrease according to the prime interest rate to account for the changes in the interest you owe. When the prime interest rate rises, your payments also go up. The same principle applies in reverse. When the prime rate determined by the Bank of Canada goes down, your payments decrease accordingly.
Fixed Payment Variable-Rate Mortgage. Payments stay the same each month despite fluctuations in the prime interest rates. The only difference is the allocation of your money toward the principal (the original loan amount) and the interest (the cost of borrowing). When the interest rates increase, a larger portion of your payments goes towards paying off the interest. If the rates decrease, more of your money goes toward the principal, meaning your mortgage is paid down faster.
Open Mortgage. An open mortgage allows you to pay off your loan before the end of the mortgage length. It does so at the expense of higher interest rates.
Closed Mortgage. With a closed mortgage, the interest rate is lower than that of an open mortgage. The drawback? If you want to pay off your mortgage before the end of your term, you will have to pay fees and/or penalties. Check with your financial institution however, if they have prepayment options where you can pay down your mortgage faster by adding to your monthly payments.
Example of a Variable-Rate Mortgage
Assume you have a 4.95% interest rate on a $300,000 3-year variable-rate mortgage with a 20-year mortgage length. You’ve chosen a fixed payment structure, which means your monthly payments would be fixed at $2,206, with $645 going toward the principal and $1,561 going toward interest.
Suppose the interest rate increases to 5,2%. Your monthly mortgage payment stays at $2,206, however, the portions allocated to the principal and interest look different. Now, $1,646 goes toward interest, which leaves $560 for the principal. Hence, you’re paying off your mortgage at a slower pace.
If the interest rate instead drops to 4.45%, you’d still pay $2,206. However, $1,451 would now be allocated to interest, whereas the remaining $755 would be applied to the principal. In this case, you’d end up paying off your home loan quicker.
Can I Switch the Type of Mortgage I Have?
Whether you’re looking to renew a mortgage or purchase your first home, you might wonder if you can change your mortgage type before the end of your term. Some lenders may allow you to switch from a variable-rate to a fixed-rate mortgage during your term, often with a fee or rate adjustment, but switching from fixed to variable typically requires refinancing.
Finding a Mortgage Lender You Can Depend On
Choosing the right mortgage is easier when you have a lender you can trust — one that’s supportive, informative, and reliable.
Find the best mortgage to suit your needs. With self-service tools like our mortgage finder and knowledgeable, supportive mortgage experts, you’ll have everything you need to make an informed and confident decision.
Get pre-approved for a mortgage today!
The Bottom Line
Variable interest rates can be a tricky option to navigate. Whether or not this type of home loan is the right fit for you will depend on your financial situation and willingness to take on extra risks.
Due to the volatility of prime rates, you should be ready to adjust your budget to varying economic conditions if you choose a variable mortgage. For further understanding of mortgages and how they work, get a free mortgage transfer eBook to make things easier.
Variable-Rate Mortgage FAQs
What happens to a variable-rate mortgage when interest rates go up?
It depends on the loan type you’ve opted for. With a variable payment structure, your monthly payments will increase when prime rates rise. If you select a fixed payment structure, your monthly payments will remain the same. However, a larger portion of your payments will go towards your interest instead of your principal.
What happens to variable-rate mortgages when interest rates go down?
It also depends on the specific type of home loan you’ve selected. With a variable payment structure, when the prime rate decreases, your payments go down, too. With a fixed payment structure, if the rates decrease, a greater portion of your money goes toward the principal.
Is a variable-rate mortgage better than a fixed-rate mortgage?
The answer to this question will depend on your financial goals and readiness to handle extra risks. If you’re open to the uncertainty of fluctuating mortgage payments in exchange for potential savings, this option might be a good fit. However, if you prefer safety and predictability, it might be better to stick with a more stable alternative.