A variable rate refers to a mortgage that has an interest rate that floats with prime rate. It’s referred to as a “floating rate mortgage.”
There are two types of floating rates:
1) A standard variable rate mortgage (VRM): The payment is fixed for the full term. As prime rate rises and falls, so does the percentage of principal you pay down with each payment.
2) An adjustable rate mortgage (ARM): The rate and payments move up and down with prime rate.
Lenders are split roughly 50/50 as to which kind of floating rate they offer. Most big banks offer the standard variable-rate mortgage. Smaller mortgage finance companies typically offer adjustable-rate mortgages.
Most variable rates are closed, meaning you cannot get out of the mortgage contract early unless you pay a prepayment charge (a.k.a. “penalty”). This charge is typically equal to three months’ interest, but not always.
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After the 5-year fixed, a 5-year variable is the second-most popular mortgage term in Canada.
In 2019, about one out of five mortgagors took out a variable rate, according to data from Mortgage Professionals Canada. That’s down from about one in four (27%) in 2018, but that percentage is expected to rise again in 2020, so long as floating rates remain competitive compared to fixed rates.
The popularity of floating rates has fallen over the past couple of years as fixed rates dipped to multi-year lows, putting them beneath most variable rates at one point. Floating rates experienced a surge in popularity again in March 2020. That’s when the COVID-19 pandemic forced the Bank of Canada to begin cutting its overnight lending rate, which pulled down prime rate by 1.50 percentage points.
The best 5-year variable rate hinges on your five-year plan and personal circumstances. The goal is to obtain the lowest overall borrowing cost, not necessarily the lowest rate.
Factors to consider when evaluating a variable-rate mortgage include:
No homebuyer should begin the journey of shopping for a mortgage rate without first comparing rates. With free resources such as RATESDOTCA’s database of 300 mortgage providers, it’s easy to see if you’re getting the best rate with the best features.
Even though most Canadians tend to opt for a 5-year fixed mortgage, the fact that 20% of buyers (and often more) take a 5-year variable tells you there are benefits to a floating rate (more on the pros and cons of floating rates below).
Be sure to ask yourself these questions when searching for a variable mortgage rate:
Whether due to a job relocation or an unforeseen life event, a variable mortgage can make the unexpected a little less stressful. If there’s any risk at all that you may need to break a mortgage before five years, a variable rate is a wise choice, given that it entails lower breakage penalties than most fixed-rate mortgages. By comparison, breaking a fixed mortgage early can result in massive costs, like this $15,000 example demonstrates.
If not, a longer-term fixed rate may be a better choice since your monthly payments will remain stable. If you could handle a potential increase in your floating rate, and still be able to sleep at night, then a floating rate is worth considering. This applies mainly to adjustable-rate mortgages. As mentioned above, variable-rate mortgages have fixed payments that alleviate payment risk to a large extent
Historical data shows variable rates typically come out ahead compared to fixed rates. But the choice for borrowers is admittedly harder these days, given how competitive certain fixed-rate terms have become. The spread between fixed and variable rates makes a big difference. Most of the time, the wider this spread, the better your odds in a variable-rate mortgage—particularly going into an economic slowdown.
All mortgage terms have pros and cons. Here are some that pertain to the 5-year variable:
Variable rates are based on a set discount or premium relative to prime rate. And prime rate typically only changes when the Bank of Canada raises or lowers its overnight lending rate.
As a result, variable rates generally take their direction from the Bank of Canada’s interest rate policy. Prime rate generally moves higher as good times approach and falls during periods of economic deterioration or crisis. This means your mortgage can be influenced by geo-political shocks, trade wars, stock crashes and, yes, even pandemics.
One other key variable-rate driver is risk premiums. The riskier lending gets, the more lenders reduce their discounts from prime rate. There have even been times in the past where discounts didn’t exist. In the financial crisis of 2008, some lenders were charging prime plus 1.5 percentage points for floating-rate mortgages. Albeit, changes in risk premiums don’t impact existing variable borrowers, only new customers.
|Year||5-yr benchmark bond yields||Avg. 5-yr variable rates|
Five-year variable rates have been higher than the lowest fixed rates since 2019, accounting for their declining popularity in comparison.
While the Bank of Canada was expected to deliver a rate cut or two in late 2019 in order to support the economy in the face of global trade wars and sagging economic data, the Bank stubbornly left rates untouched into 2020.
But that changed with the arrival of the COVID-19 pandemic, which wreaked havoc on the economy and forced the BoC to drop rates by a full percentage point. That finally dragged down floating rates, once again bringing them back below most fixed-rate pricing.
While those savings were initially passed along to borrowers in the form of falling variable rates, they quickly pulled a U-turn and started climbing back up as risk premiums grew. Indeed, soon after the BoC’s second rate cut of 2020, most banks and other mortgage lenders began slashing their discounts on prime. In some cases, they tacked a premium on top of prime, due to growing liquidity and credit risk concerns.
|Year||Avg. of lowest nationally available insured rates||Avg. of lowest nationally available uninsured rates|
The COVID-19 pandemic has taken an immense toll on Canada’s economy — and will continue to take a toll for the foreseeable future. Canada is very likely in a recession as we speak with record unemployment claims. For these reasons, and given we’re already close to zero on the overnight rate, chances are that floating rates will neither rise nor fall significantly from their current levels for multiple years.
Should credit concerns ease, that would pave the way for variable rates to trend back lower over time as risk premiums subside.
But if market worries persist, specifically concerns over liquidity and funding costs, variable rates could remain elevated from where they otherwise would be.
At the time this is being written, economists are generally projecting no change in prime rate for 2020 and 2021.
Banks use a variety of sources to fund 5-year variable mortgages, including:
A blended cost of funds is typically derived from the above sources and that forms the basis of 5-year variable mortgage pricing. On top of that, lenders try to earn enough to pay staff, sales and marketing expenses, overhead and a small profit (which often amounts to less than ½ percent of the mortgage principal plus renewal and servicing revenue).
Here’s a collection of recent stats on Canada’s second-favourite mortgage type: