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A variable-rate mortgage, just like it sounds, is the opposite of a fixed rate. Unlike its counter mortgage, its interest rate will fluctuate with the market or the “prime rate”. The terms of a variable-rate mortgage are usually along the lines of ‘prime plus or minus a pre-determined percentage’.
If your term states that the interest will be the prime rate – 0.5% and the prime rate is sitting at 4%, your interest rate (as long as the prime stays like that) would be 3.5%.
Just like the fixed-rate mortgage, the ‘5-year’ in a variable-rate mortgage refers to a 5-year term. This is the time you are locking yourself into paying the determined variable rate. This will affect your monthly payment in one of two ways. The first is a set payment where the interest portion fluctuates.
This can benefit you if the interest rates go down because the remainder of the set payment will be applied directly to principal. But this can go the other way if interest rates go up because less of your payment will be applied to the principal balance of your mortgage.
The other option is to have a fixed payment being applied to the principal balance and have the interest fluctuate with the rates. This would give you an unpredictable mortgage payment month-to-month, but at least you would be paying down a steady amount of principal.
There are a few things to keep in mind regarding variable rate mortgages. It is true, that the lower interest rate you will have a variable-rate mortgage can save you money short term and potentially long term.
However, if rates suddenly go up, you will be charged the difference in interest. It will be applied against the principal balance on your mortgage. This will either cause your monthly payments to go up or if your mortgage is structured so your monthly payments are fixed, then your payment schedule may change.
It is worth mentioning that a 3-year term may be an option to consider if the market doesn’t seem entirely stable. With considerably lower penalties for breaking the contract early, you wouldn’t take such a hit if you needed to get out of the contract or wanted to upgrade your house before the term was up.
As always, it is best to do your homework and use the free tools that are available to you, so that you can compare all the options and figure out which one works the best for you.
There are a couple reasons that make a 5-year variable-rate mortgage the most popular floating-rate mortgage that Canadians choose: Lower cost and greater flexibility.
As a general rule, with a 5-year variable mortgage, you will save more money in interest when compared to a 5-year fixed mortgage. Like we mentioned earlier, rates have been dropping for years, but there is still a significant different between a variable and a fixed mortgage.
Also, variable-rate mortgages generally have smaller penalties for breaking the contract before the five-term expires. So this will give you a higher degree of flexibility if you think you may want to upgrade your house or switch lenders early. Keep more of your hard-earned house equity in your pocket!
Where there are pros, there are cons and because of the potentially volatile nature of interest rates, a variable-rate mortgage will leave you vulnerable to interest rates suddenly sky-rocketing. If this happens, you may find yourself paying a heck of a lot more than you expected.
Because of the potential for rates to increase, this also leaves the lender with the liability of the borrower being unable to pay for the increased payment. As a result, they will require you to provide proof that you can make a payment based on the posted 5-year fixed rate. This gives them the confidence that you can make the payments should they increase. According to the Bank of Canada, if you have less than 20% equity, you will be required to have proof of income proving that you are capable of making payments based on interest rates even greater than the 5-year fixed rate.
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