Mortgage Basics

What is a Variable-Rate Mortgage (VRM)?

What is a Variable-Rate Mortgage (VRM)?
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  • Ashley Howard
| 23 July 2024
Reviewed, 27 September 2024
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    Variable mortgages gained considerable attention when ultra-low interest rates during the pandemic prompted many Canadians to choose variable for their mortgages. Historically, variable interest rates have typically trended lower than fixed rates, allowing borrowers to save on interest costs, qualify for a larger mortgage, and take advantage of lower mortgage payments. 

    With projections that the Bank of Canada will cut policy rates further this year, many borrowers may again consider variable mortgages in the hope that rates will come down. Canada has two types of variable mortgages: variable-rate (VRM) and adjustable rate (ARM). Although both are commonly known and referred to as variable mortgages, this post will take a closer look at variable-rate mortgages (VRM).

    Key Takeaways

    • Variable-rate mortgages (VRM) have fixed payments with variable interest and principal components that fluctuate based on changes in interest rates. 
    • Variable rates are based on lender prime rates plus a premium or discount.
    • Adjustable-rate mortgages (ARMs) are a type of variable mortgage that have variable mortgage payments that increase or decrease based on changes in interest rates.

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    What Is a Variable-Rate Mortgage (VRM)?

    Variable-rate mortgages (VRM) have fixed mortgage payments over the mortgage term. However, the interest and principal components that make up your mortgage payment are variable and will change with changes to interest rates. 

    If interest rates increase, the amount that goes toward interest will increase, and the amount that goes toward principal will decrease. If interest rates decrease, the amount that goes toward interest will decrease, and the amount that goes toward principal will increase. 

    Since mortgage payments are fixed, when rates decrease, this can help you pay off your mortgage faster since more goes toward the principal, reducing the amortization.

    If rates increase, you could reach a point where you are no longer paying down the principal on your mortgage. If this happens and your mortgage payments cover interest only, this can increase your amortization and put you at risk of hitting your trigger rate or trigger point. When this occurs, you may need to bring your mortgage back on schedule through lump sum payments, increasing mortgage payments, or refinancing and extending the amortization.

    How Does My VRM Payment Change When Rates Change?

    If your original mortgage is $400,000 on a 5-year variable term at 5.95% and a 25-year amortization, your monthly mortgage payments would be approximately $2,565. This is split with approximately $598 toward the principal and $1,967 toward the interest. 

    If interest rates increase by 1% to 6.95% after the first year, your payments will remain the same, so you will continue to pay $2,565 a month. However, approximately $2,275 will now go toward the interest and only $290 toward the principal. If rates decrease by 1% to 4.95%, approximately $1,620 will go toward the interest, with $945 going toward the principal. 

    What Is the Prime Rate and How Does It Impact Variable-Rate Mortgages?

    Prime rates are set by lenders and are tied to the Bank of Canada policy rate. All variable interest rates are set based on the lender’s prime rate. The Bank of Canada implements monetary policy by adjusting policy rates. When this happens, lenders will align their prime rates, typically adjusting them with a spread 2.20% higher than the policy rate.  

    What Impacts the Policy Rate?

    The policy rate is adjusted based on inflation, the health of the Canadian economy, and global economic conditions. The BoC influences short-term interest rates through monetary policy. They do this by adjusting the policy rate, lowering rates to stimulate the economy or increasing rates to discourage borrowing and spending to slow the economy. The BoC aims to keep inflation within a target range of 2-3% and will adjust the policy rate when needed to keep within this target. 

    How Often Does the Policy Rate Change?

    The policy rate is adjusted on 8 fixed dates each year, prompting lenders to adjust their prime rates accordingly. However, the BoC doesn’t necessarily change rates at each announcement. They can either hold the policy rate steady, leaving it unchanged, or increase or lower rates based on what the economy requires to bring inflation back to the target range. 

    When the policy rate is adjusted, it is done using a unit of measurement called a basis point. For example, if there is an announcement that the policy rate will be reduced by 50 basis points, this indicates a decrease of 0.50%. The policy rate can be adjusted by any number of basis points in increments of 25 at each announcement. 

    What Determines the Prime Rate?

    Lenders determine their prime rates based on the policy rate set by the Bank of Canada. For example, if the Bank of Canada policy rate is 4.50%, you can expect that, in most cases, your lender’s prime rate will be 2.20% higher or 6.70%. 

    If the BoC keeps the policy rate the same, your lender’s prime rate will remain at 6.70%. If the BoC increases the policy rate to 4.75% or 25 basis points, your lender will do the same to their prime rate, raising it to 6.95%. If the BoC decreases the policy rate from 4.50% to 4.00% or 50 basis points, your lender will reduce their prime rate to 6.20%.

    How is a Variable Rate Determined?

    Interest rates on variable mortgages are determined based on your lender’s prime rate plus a premium or minus a discount. For example, if your lender’s prime rate is 6.95%, your variable mortgage may be quoted as prime – 0.50%. This means you have a discount on your rate, bringing it to 6.45%. 

    Your discount will remain the same for the remainder of the mortgage term regardless of changes to interest rates. So, if prime rates increase to 7.20%, your interest rate will increase to 6.70%. If prime rates decrease to 6.70%, your rate will decrease to 6.20%

    Types of Variable Mortgages

    There are two types of variable mortgages: variable-rate and adjustable-rate. Changes to interest rates impact both, but they are different in terms of how any changes will impact your mortgage payments. 

    Variable-rate mortgages (VRM)

    VRMs have fixed mortgage payments that remain the same for your entire mortgage term. If interest rates change during your term, the principal and interest components that make up your mortgage payment will change. If interest rates decrease, more of your payment will go toward the principal, helping you pay off your mortgage faster. If interest rates increase, less of your payment will go toward the principal, potentially increasing the time it will take you to pay off your mortgage. 

    Adjustable-rate Mortgages (ARM)

    ARMs have variable mortgage payments that change when interest rates change. The principal component of an ARM remains fixed, while the interest component adjusts, increasing or decreasing with changes to interest rates. If interest rates increase, your mortgage payments will increase; if interest rates decrease, your mortgage payments will decrease. This type of variable mortgage keeps your amortization always on track. 

    Frequently Asked Questions

    When would a variable-rate mortgage be a good idea?

    Variable-rate mortgages (VRM) can be a good idea if interest rates are expected to fall during your term. As rates fall, more of your fixed mortgage payment will be allocated toward the principal, which will help you pay down your mortgage balance faster and reduce the interest-carrying costs on the mortgage.

    Are interest rates higher on variable-rate mortgages?

    Interest rates on variable-rate mortgages (VRM) are set based on the lender’s prime rate, which influences all variable and adjustable mortgages with the lender. Historically, variable rates have been lower than fixed rates until recently, when we have seen variable rates shift to higher than fixed rates.

    How do I know if I’m close to my trigger rate or trigger point?

    The easiest way to check if you are close to your trigger rate is to check the mortgage agreement you signed with your lender. Your trigger rate should be outlined in your documents and will be accurate if you have yet to make any prepayments during the term. 

    Trigger points are more complicated to determine as it depends on your original mortgage balance and the loan-to-value (LTV) ratio. If you have hit your trigger rate, you should anticipate that you may soon hit your trigger point.

    Final Thoughts 

    While variable mortgages may not be as popular as a few years ago, they still have the potential to offer interest savings when rates are expected to decrease. VRMs can help you save on interest costs when rates decrease, and the fixed payments over the term help you pay off the mortgage faster when rates decrease. 

    Contact our mortgage professionals today to see if a variable mortgage is right for your mortgage needs.