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Will Rising Interest Rates Affect My Variable Rate Mortgage?

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 homeowners 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 mortgage rates affecting his 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 fluctuates 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 the 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.

Comments

  1. Krantcents

    I see how you are reducing the risk, however what are you going to do in 5 years when it adjusts. It is very likely that interest rates will be higher in the future. Therefore you will have a higher interest rate and it will adjust. If you take the fixed rate now, you do not have to worry about that.

    • Echo

      @krantcents – the fixed rate term is only for 5 years, same as the variable rate term. Regardless if interest rates are higher in 5 years, I will still be faced with the choice of fixed vs. variable term again.

  2. Tyler

    Over the long haul a variable rate mortgage will save you thousands of dollars in interest, but that doesn’t mean that this mortgage is right for everyone. If you are on a fixed income a closed mortgage may be more suited for you so that you know exactly what your future holds and how best to plan for it. After all you can also prepay your closed mortgage without penalty to a maximum predetermined by your lender.

  3. Doctor Stock

    Great post… do you know if brokers receive a greater commission from the institutions for selling “fixed” products… the longer the greater the commission? It seems most I deal with always are pushing the fixed rates. Pardon the skepticism, but I remember investing in mutual funds only to discover the way my advisor was paid… then his advice really made sense.

    • Echo

      @Doctor Stock – Apparently brokers get a higher commission the longer the term you sign for (i.e. 5 years), not whether you choose fixed or variable. Some brokers claim to push the 5-year fixed rate more because that’s what people want. That’s reasonable, most people don’t understand variable rate terms, but if they did they would realize that they could save money.

    • Tyler

      Well a longer term mortgage would infact pay more to a mortgage broker. We put the needs of our clients first at Conexia Mortgage, and if you need a shorter term mortgage than that is the product we will place you in, but with rates as low as they are it is often better for the client to take a longer term.

  4. Ben

    It seems like a big risk for $7k in savings. Say in 3 years interest rates increase, how much will you actually save then? You are basing the $7k savings on if interest rates stay as they are now. In 1-2 years, what’s the savings if interest rates increase by 1-2%?

    When my wife and I bought our first house we decided to go for a fixed rate, I think I’ll sleep better at night.

    • Echo

      @Ben – There are many “what if” scenarios when looking at mortgage options. In this case, interest rates would have to rise at least 1.75% before the fixed term became a better option.

      Don’t forget that I can still convert to a fixed rate if I get nervous about rising interest rates during my term.

      • Ben

        If you convert to a fixed rate does it cost you a bit of money for the change? I know these are Canadian terms, slightly different than what US banks charge. If we had to convert to a fixed, it would cost us about $2500 in bank fees.

  5. Crystal

    We specialize in working with first time home buyers exclusively and we find that most first time buyers prefer the long term security in a fixed 5 year mortgage. It seems to be the most popular with our first time home buyers.

  6. G. Williams

    I have two home loans and both are on the variable interest rates. Somehow, I’ve been able to reduce the interests tremendously by ensuring that I pay more than the stipulated sum every month.

    One of the ways I do this is by managing my credit card account. By connecting my home loan accounts with my checking account, I usually pump in monies into the checking account (meant to be used for paying credit cards at its due date) in advance and let it sit there for at least 3 weeks before transferring it to settle my credit card statement. The amount sitting in the checking account for 3 weeks helps to lessen the calculation of interests payable for that month.

  7. Canadian Mortgage Advisor

    Given the stock market advances this week – fixed rate may start to go up soon.
    Nice post.

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