What happens to your mortgage payments when interest rates rise? Many people mistakenly believe that their payments will fluctuate when interest rates change. They end up paying a premium for the fixed rate so they can sleep better at night knowing their mortgage payment will remain constant.
Even though there is overwhelming evidence that selecting a variable interest rate mortgage will save money over the 5-year fixed interest rate, many home owners still fear what might happen to their mortgage if interest rates rise.
I recently explained this to a friend of mine after telling him about my variable rate mortgage of prime minus 0.80%. He mentioned that he went through a mortgage broker to secure a 5-year fixed rate of 3.89% last year, and he thought that was a good deal because he wouldn’t have to worry about rising interest rates affecting his mortgage payments.
Will My Payment Change If Interest Rates Rise?
According to TD Canada Trust, with a variable rate mortgage the interest rate is set on the first day of each month, and your payments remain the same. The closed variable rate mortgage also gives you the ability to lock in your interest rate by converting to a fixed rate mortgage at any time, as long as the new term is at least the lesser of 3 years or the current remaining term.
Let’s look at an example:
If I took out a $250,000 mortgage with a variable interest rate of 2.20% paid monthly over a 25 year amortization schedule, my total monthly mortgage payment would be $1,083. Because my total payment is fixed, and due to the odd number of days in each month, the amount I’m paying on principal and interest fluctuate even without a change in the interest rate.
5-year term, no change in interest rates
- Principal payment – $661/month on average
- Interest payment – $422/month on average
- Total payment – $1,083/month
What happens when the interest rate rises throughout my 5-year term? How will rising interest rates affect my variable rate mortgage?
We’ve already established that my monthly payment is fixed, therefore an increase in interest rates will affect the amount that I pay towards principal and interest. Clearly if interest rates climb throughout the 5-year term, more of my monthly payment will go towards interest and less towards principal.
If the amount of interest that has accrued in any month ends up exceeding the amount of my regular principal and interest payments, the excess, being deferred interest, will be added back onto the total principal amount on the first day of the next month. In my case, this could potentially occur if the interest rate on my mortgage rises above 4.50%.
Can You Save Money and Sleep at Night?
Let’s assume that my friend and I have the exact same mortgage amount, terms and amortization schedule. After 5 years of paying 3.89% interest, my friend has paid a total of $78,011 in principal and interest, and the remaining balance on his mortgage now comes to $217,209.
If my 2.20% variable interest rate mortgage remains constant throughout the 5-year term, I will have paid a total of $64,975 in principal and interest, and the remaining balance on my mortgage now comes to $210,300. That’s a savings of over $7,000 in interest alone, which is enough to consider refinancing your mortgage.
Of course the whole point of choosing the fixed rate is for the sleep at night factor in case interest rates rise significantly during the 5-year term. But can you save money while still protecting yourself against the risk of rising interest rates?
My solution is to choose the variable rate, but adjust your payment to at least the 5-year fixed rate. That way you’re taking advantage of the lower interest rate and making extra principal payments, your payment stays the same, and you’ve built in your own insurance in case interest rates rise. Now that sounds like peace of mind to me.