In light of the recent announcement that the Bank of Canada has cut its overnight lending rate by 0.5%, it’s appropriate to write a bit more about the benefits of adjustable/variable rate mortgages (ARMs and VRMs).
Adjustable/variable rate mortgages are mortgages whose interest rate fluctuates as the prime lending rate changes. The prime rate is tied directly to the Bank of Canada’s overnight lending rate (unlike fixed mortgage rates, which are based on bond prices). While choosing a fixed rate mortgage will lock in your interest rate for your mortgage term, a variable/adjustable rate mortgage will quite often give you a better rate, which leads to lower monthly payments and savings on the amount of interest you’re paying the mortgage lender.
A few years ago, Manulife did a study on variable/adjustable rate mortgages versus five-year fixed mortgages. They found that over the past 50 years, nine times out of ten, mortgage holders were better off with the floating rate (ie: the variable/adjustable mortgage offered a better interest rate than the five-year fixed mortgage). The difference between the variable and fixed interest rates can be as high as 1.5%, which is significant.
The difference between fixed rates and adjustable/variable rates stems from the fact that fixed rates act like insurance they guarantee you which rate you’ll be paying for a certain amount of time, and eliminate the risk of not knowing what your rate will be. Therefore, you pay more for fixed rates…you could call the difference between fixed and adjustable/variable rates the insurance premium.
Because variable/adjustable rates are usually lower, the mortgage holder can save a fair amount of money in interest, and as a result their monthly mortgage payments are lower. For example, take a mortgage amount of $200,000. If someone were to take a five-year fixed mortgage out, the interest rate would be 5.84% (as of March 4, 2008). Their monthly payment would be $1,260.65, and after five years they will have paid $54,903.85 in interest to the mortgage lender, and paid down $20,735.15 of their original mortgage amount (the previously mentioned $200,000). Now, if that same person were to take out a variable rate mortgage instead, their interest rate would be prime minus 0.7%, therefore 4.55% (as of March 4, 2008). Their monthly payment would be $1,112.51, and after five years they will have paid $42,488.53 in interest and $24,262.07 towards their principal. With the variable rate mortgage, the mortgage holder’s payments are more manageable, they pay $12,415.32 less in interest, and pay their principal down by $3,526.92 more.
Overall, variable/adjustable rate mortgage do save you money when compared to five-year fixed mortgages. However, in the end, it really depends on each person and their situation, as well as their aversion to risk. If someone if more comfortable with a fixed rate and the peace of mind that comes with it in the event interest rates rise, then that’s what they should go with.
That being said, variable rates are currently (as of March 4, 2008) prime minus 0.7%, which is a fair amount lower than current fixed rates. This is because the Bank of Canada has dropped rates once again, which is good news for those who currently have variable/adjustable rate mortgages, or are looking at variable/adjustable rate mortgages as an option.
If you’d like to know more about variable and/or adjustable rate mortgages, or would like to see if they’re right for you, please contact First Foundation today.