There are two main types of mortgages – variable rate and fixed rate – and a less common hybrid that blends the two into one mortgage.
A variable rate mortgage doesn’t have a static interest rate because the rate is tied to a benchmark or reference rate. In Canada, the prime rate is the most common reference rate, which is driven by the key policy rate set by the Bank of Canada.
Variable mortgage rates are stated as the reference rate plus or minus some percentage. The plus/minus amount will vary based on the creditworthiness of the mortgagor, amount of the down payment relative to the purchase price, and size of the mortgage relative to income, as well as savings or other assets. Generally it’s a plus, but sometimes there’s enough competition that lenders will offer lower rates, or if the borrower is very low risk.
In addition to an interest rate that fluctuates, the payments on variable rate mortgages can too. When interest rates increase some variable rate mortgages will require higher payments while some offer cap protection. With a cap the mortgagor continues to make the same payments, but more dollars go to interest and fewer toward paying down the principal.
If rates go down, payments could be adjusted downwards and if not, more of the future payments get applied to the principal and the mortgage could be paid off sooner than anticipated.
In the absence of a cap, mortgage professionals say that variable rate mortgagors should budget for 200 basis points of rate hikes, which would increase monthly payments by about $100 per $100,000 of principal.
Note that mortgage rates are not mandated to adjust in lockstep with changes in the prime rate, but they usually do, within +/-5 basis points (0.05%).
