This article has been updated from a previous version
When it comes to applying for a mortgage, there are two basic options for homeowners to consider: fixed rate and variable rate mortgages.
With a fixed rate mortgage, the borrower negotiates the interest rate they’ll pay their financial institution and it’s locked in at that rate for the duration of the mortgage period - typically five years. If interest rates go up or down, the mortgage payment stays the same.
A variable rate mortgage, however, is not locked in at a set price, and typically shifts according to interest rates set by Bank of Canada (BoC).
Traditionally, the benefit of a fixed-rate mortgage was that borrowers could anticipate their monthly payments and plan accordingly — even though those rates were often higher than variable rates.
But what happens to your payments if you have a variable rate mortgage and interest rates change — or increase dramatically, as we’ve seen in the last year?
The short answer: It depends
Every time you make a bi-weekly or monthly mortgage payment, a portion of the money goes towards paying down the principal and the rest is taken off as interest. At the beginning of your mortgage amortization period, the majority of the payment goes towards interest. As you pay off the principal owed over time, the ratio skews to less interest and a higher percentage goes towards the principal — you can see this in action using the RATESDOTCA mortgage payment calculator.
There are two types of variable rate mortgages. With an open variable rate mortgage, your mortgage payment will increase or decrease as rates change so that the interest to principal ratio remains the same. The downside here is that if interest rates climb sharply, homeowners may have difficulty covering higher mortgage payments.
With a closed variable rate mortgage, your regular payment remains the same, regardless of whether interest rates change. If interest rates go up, the portion of your payment that goes towards interest, however, will increase. That means it will take longer to pay down the principal. But if rates go down, you’ll be paying more principal and less interest with every payment.
The one exception is if interest rates rise to the point that your payment doesn’t cover the interest portion of the payment (known as the “trigger rate”). In this situation, your lender will either increase your payment amount or require you to make supplementary payments to cover the difference.
Read more: What is a trigger rate?
Up until recently, variable rate mortgage holders could assume lower interest rates than those with fixed rate mortgages — especially initially, once comparing insurance rates and locking the in lowest available rate.
With the big five banks, the difference between posted fixed and variable rates could be as much as two percentage points. In short, borrowers opting for variable rate mortgages were gambling that interest rates will stay low long enough that they could come out ahead.
However, that gamble doesn’t always work out. Since 2022, the BoC has instituted a long series of rate hikes bringing the target for the overnight rate to 5% as of July 2023 — the highest in 22 years. This has left homeowners with variable rate mortgages scrambling to keep up.
Currently, the lowest available five-year fixed rate is 4.89%, while the lowest available five-year variable rate is 5.75%. If the target rate comes down, variable rate payments will follow shortly — but many new mortgage-holders may be scratching their heads at which the best bet is.
There are some other caveats to keep in mind with variable rate mortgages. For one, variable rate mortgages typically come with fewer prepayment privileges, limiting your ability to pay your mortgage off faster.
Lenders will also typically remind buyers that they can “convert” their variable rate to a fixed one at any time if they start to get nervous about rising rates. But if you do that, it will be at the current rate at the time of conversion. Or possibly higher than when you signed on a mortgage – and the bank will not offer you any discount on their posted rate.
The situation looks bleaker than ever for every mortgage-holder, and there’s very little conventional wisdom that will apply to sky-high rates in an inflationary environment. If you find yourself locked into a variable rate mortgage and unable to cover the principal on your payments, you may consider extending your amortization period — just talk to your lender and make sure you’re aware of the risks, first.
And if you’re just looking for a mortgage now, whether it’s variable or fixed, you can still shop around to make sure that you’re getting the best rate available.