WHAT’S THAT? VARIABLE RATE?
An adjustable rate may be right for you.
Last time around we talked about fixed interest rates. In our simple example we borrowed $100 for a year, and paid 4.0% interest (or $4) to do so. The total amount owing after 12 months was $104.
Variable rate mortgages on the other hand, what some people also call “adjustable rate mortgages,” are similar to fixed-rate mortgages in that a lender gives you the money necessary to buy a home and you agree to pay interest on that money, but that rate is subject to variation.
In most cases, you agree to a specific payment amount and a payment frequency such as once a month, twice a month, or every two weeks (don’t worry, we’ll talk about payment frequency in an upcoming post).
The main difference is in how much of your payment goes to interest, and how much goes to paying down the principal (i.e. the amount owing), on the mortgage.
You might notice that the variable rates posted by banks and other lenders are generally lower than fixed rates. Lower is better, right? Well, yes and no.
Yes, lower is better. If someone gives you the option of paying either 2.0% or 4.0%, with both of them being fixed rates, your choice is a no-brainer. A little math tells us that if you choose the first rate, you’ll save $2,000 for every $100,000 you borrow so yes, saving $2K is a good thing.
However, would you still choose 2.0% if we couldn’t guarantee the rate? It might go up after all and we can’t tell you whether it will or won’t, or by how much.
It might go up by one percent or one and a half percent, which would still be lower than 4.0%; but the rate could also go up by two or three percent over the next couple of years. It probably won’t, but it could and at the end of the day, we just don’t know. It could even go down!
Starting to get confusing, perhaps but stay with me.
If we look back to our example, we borrowed $100 and paid $104 at the end of the year for the loan. The rate was fixed. In our variable rate example however we’ve gone with a lower rate, one that might change before the end of our contract.
With our new lower rate you’re borrowing that same hundred bucks, but we agree that you’ll pay $102 after a year. Well, probably. Maybe you’ll pay a little less (say, $101.50), or maybe more, as much as $106. But yeah, most likely you’re in for $102 after a year. Would you choose that, or would you prefer a slightly higher rate that you can predict to the penny?
HOW IS THAT FINAL AMOUNT DECIDED?
Variable rates are tied to decisions made by the Bank of Canada — those influence what we call the prime rate (we’ll talk about this in more detail in another post).
The gist is pretty simple. If the Bank of Canada rate goes up, so to does your rate and that means a smaller portion of each payment goes to principal. When the Bank of Canada rate goes down, so to does your rate and that means your payment sends a little bit more to principal.
If you’re the type of person who will spend sleepless nights worrying about what Mark Carney (the governor of the Bank of Canada) had for dinner, variable rates aren’t for you. If you’re willing to take a small amount of short-term risk to have your payments apply a little bit more to the amount owing, then this just might be an option worth considering.
In future news posts we will talk about interest (the amount of your payment that goes to the mortgage), principal (the amount of your payment that goes toward the house), and ten-dollar words like amortization.