The decision to choose a variable rate mortgage (aka VRM), adjustable rate mortgage (aka ARM) or fixed rate is not always an easy one. It should depend on several factors including, but not limited to, your ability to withstand fluctuations in mortgage payments, your desire to keep payments the same throughout the mortgage term, and pay as little interest as possible.

To make an informed decision, consider your lifestyle and the historical trends.

When it comes to VRM/ARM vs. Fixed-rate, it is important to understand the fundamentals of how interest rates for these types of mortgages are determined.

Fixed-rate mortgages are so named as they are based on a fixed interest rate that is set for the duration of the term, with fixed payments. Fixed mortgage rates are indirectly based on Government of Canada bond yields. That’s why the most popular mortgage term in Canada (the 5-year fixed) closely follows the 5-year bond yield. While it can deviate for short periods, the spread (difference) between 5-year yields and 5-year fixed rates always comes back to their long-term average. Fixed-rate mortgages often appeal to borrowers who want stability with their payments. For example, young couples with large mortgages relative to their income might be better off opting for a fixed-rate in order to help them manage their monthly budget more easily, or prefer the peace of mind knowing their payment will not change during the term of the mortgage. Recent times have seen significant changes to fixed rates. Review the latest commentary here.

On the other hand, a VRM or ARM mortgage often allows the borrower to take advantage of lower rates – the interest rate is calculated on an ongoing basis at a lender’s prime rate plus or minus a set percentage, often referred to as the “discount off prime”. VRM and ARM mortgages fluctuate with the Prime rate.

The Prime rate in Canada as of June 1st is 3.70% and is the interest rate that banks and lending institutions use to set the interest rates for many types of loans and lines of credit.

These can include credit cards, HELOCs, VRM and ARM mortgages, car and auto loans, and more. This can either mean fluctuations in your payment (ARM), or if you have set payments, the portion of your payment that goes towards either principal/interest repayment (VRM). You can sometimes expect a financial reward for going with the VRM or ARM, although the precise magnitude will ebb and flow depending on the economic environment.

Due to the uncertainty and potential fluctuations that can occur with a VRM or ARM, choosing either Fixed, VRM or ARM comes down to your comfort level. Some individuals either dislike uncertainty or have no wiggle room in their budget for potential changes in payment. For these clients, a fixed rate could be the best option.

Borrowers who opt for variable or adjustable rate mortgage have a unique opportunity to take advantage of lower interest rates. If you have a VRM or ARM, you can either set a fixed-payment so that, if the interest rate drops, you are paying more towards the principal portion of your loan each month. Or, if you have flexible payments, you may see your monthly payments drop in accordance with decreases in the Prime rate. Since every 10% increase in payment can take 3 years off your amortization, setting fixed payments provides extra benefits. After all, extra money towards the principal can help make a difference over the life of a 25- or 30-year mortgage amortization.

Another benefit of VRM or ARM is that, if you choose to sell before the mortgage term is up (breaking your mortgage), the penalty is typically only three months’ interest as opposed to the possibility of a much heavier interest rate differential (IRD) calculation used to determine fixed-rate mortgage penalties. Penalties to break variable or adjustable mortgage rates are less significant than the penalties to break a fixed-rate mortgage.

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Note: There are 2 types of Variable Interest Rates as mentioned above, outlined below:

Variable Rate Mortgage (VRM):

A Variable Rate Mortgage payment stays the same, and the portion of the payment which goes towards interest is adjusted. When rates drop, a greater portion of the payment goes towards the principal, which helps pay the mortgage off faster. The amortization is the item that changes in this variable rate type. You can increase your payments and/or take advantage of prepayment privileges in order to maintain or decrease your amortization. The only time the payment will change is when the prime rate increases so much that the payment is not covering all interest payments, at which point the payment will increase. When interest rates increase, the principal and interest amount may no longer cover the interest charged on the mortgage. The interest rate this occurs at is called the Trigger Rate. Variable interest rate mortgages can exceed their trigger rate until they reach what is known as a balance called the Trigger Point. When this happens, you will be required to adjust your payments, make a prepayment, or pay off the balance of the mortgage.

Note: VRM rate type is appealing to investors buying investment properties since the interest portion paid is tax deductible.

Adjustable Rate Mortgage (ARM):

An Adjustable Rate Mortgage payment changes when the Prime rate changes. Typically you would receive a notification from the lending institution outlining the new mortgage payment. When rates drop, your mortgage payments go down. The amortization stays the same, but the payment amount changes.

Note: ARM rate type is appealing to owner-occupied homebuyers as this rate type requires less active monitoring. Your payments adjust automatically when the Prime rate increases or decreases.

Most major banks offer VRM and most monoline lenders offer ARM. Some lenders allow you to choose.

Your best option is to have a candid discussion with me to ensure you have a full understanding of the risks and rewards of each type of mortgage.

If your mortgage is maturing in the next 90-180 days and you’re not quite sure what to do, it is a good idea to get in touch with me. I can help you assess which rate type is best for you.