The 5-year variable rate mortgage fluctuates with short-term interest rates and has a good reputation for saving borrowers money over time. Variable mortgages come in two forms: open and closed.
A closed 5-year variable binds you to the terms of your mortgage for a duration of 5 years. A variable open term gives you the flexibility to move to a fixed rate at any time, but interest rates are usually higher.
How do variable rate mortgages work?
Variable rates are usually expressed as a function of the prime lending rate posted by banks, plus or minus a set amount based on the credit conditions at the time. For example, a variable mortgage advertised as ‘prime minus 0.5,’ means the interest rate would be whatever the posted prime rate is less half a percent: if prime is 3%, your variable rate would be 2.5%.
The prime rate moves in conjunction with the Bank of Canada overnight rate. So when the Bank of Canada raises or lowers its lending rate, your variable mortgage moves up or down by the same amount within a few days.
With variable mortgage products your payments can be calculated in one of two ways:
- Pay a set amount each month: the proportion of interest you pay changes based on the interest rate at the time. You can take advantage of today’s falling rate environment and pay down more of your principal while maintaining a constant payment.
- Pay a certain amount of principal and interest: the amount you pay each month moves up or down as interest rates change.
Why you should choose a variable rate
Variable mortgages are less popular than fixed rate mortgages (only 31% of Canadian borrowers choose them), but variable rates have history on their side. Studies reveal that in the post-war period, variable rates were cheaper than fixed rates more than 90% of the time. Recent history is no exception:
Put simply, most borrowers will generally pay less interest and discharge their mortgage faster with a variable rate. If you bear the interest rate risk of your mortgage, you won’t have to pay a financial institution to do it for you.
The risks of the variable rate
Variable borrowers ultimately pay less interest on their mortgage, but many Canadians still prefer the security of fixed rates.
Some economists expect floating rates (variable rates) to rise in the next 18-24 months as inflation forces central banks to tighten policy, and variable borrowers are usually the first to feel the pain of higher rates. In other words, your payments could be much higher a year or two from now. Be prepared for this scenario and make sure you can afford bigger payments if necessary. At some point, interest rates will start rising again!
If you’re still debating between variable and fixed rates, try our comparison tools. Knowing which mortgage offers the lowest rate will help jumpstart your decision.