The Ultimate Guide to Adjustable-Rate Mortgages in Canada

When it comes to buying a house, the laundry list of choices you’ll have to make can feel overwhelming. How much mortgage can we afford? What should we offer? Does this house suit our needs for the next several years? But, in many ways, home buyers are lucky that so many options exist.

Mortgages are built so that the homeowner may choose a personalized plan that works with their financial situation and lifestyle. To select the perfect mortgage, one of the most important questions you’ll have to answer is whether you should choose a fixed or adjustable-rate mortgage.

A fixed-rate mortgage is a mortgage loan that’s interest rate does not change over the chosen term. A variable or adjustable-rate mortgage, on the other hand, the interest rate is fixed initially. Still, the number resets periodically, either monthly or annually, based on the current market conditions. 

Mortgage terms can vary from as little as six months up to 10 years. The most popular term length for Canadian mortgages is five years. You’ll renegotiate a new interest rate and term at the end of your period.

What is an adjustable-rate mortgage?

If you choose an adjustable-rate mortgage (ARM), the interest rate is linked to your lender’s prime rate. Therefore, your mortgage rate will also alter whenever your lender changes that prime rate. If the prime rate goes up, your interest rate will likely increase by the same amount. The same goes for if the prime rate goes down.

The prime rate is a benchmark typically influenced by the Bank of Canada (BoC), and as of March 2, 2022, the prime rate in Canada is 2.7%. 

So, although your regular monthly mortgage payment stays the same, the interest rate depends on the market conditions, impacting how much of your monthly payment goes towards the principal amount — or the initial mortgage amount — versus the interest. Keep in mind that if your monthly payment amount is not sufficient to cover the interest, your mortgage payment will increase.

To determine what your principal and interest are over the course of your mortgage, you’ll need to look at your amortization schedule. Lenders use amortization schedules to show homeowners their loan repayment schedule based on the maturity date. 

For example, in Canada, your mortgage amortization period can be up to 25 years if your mortgage has Canadian Mortgage and Housing Corporation (CMHC) insurance, which typically means you put less than 20% down on your home. However, if you put more than 20% down on your home, your amortization period can be 35 years. 

Say you bought a home for $400,000 with a 25-year mortgage and you averaged 4% interest over it’s lifetime, you would make 300 loan payments. Your total at the end of the amortization period would be $633,404.21 meaning you’d paid $233,404.21 in interest. 

Typically, most adjustable-rate mortgages have maximums that limit how much your interest rate will rise each year — or throughout the loan term. Lenders describe this as a prime plus or prime minus alongside a percentage point. So, for example, the lender’s prime rate could be 2.4%, and your mortgage agreement could be a prime plus 0.6%, which means your interest rate will total to 3%. If the prime rate increases to 3%, your interest rate will increase to 3.6%. You can confirm this prime plus or minus with your lender.

What is the difference between an open and closed mortgage?

There are two types of mortgages to consider: open and closed. Adjustable-rate mortgages can be either-or, but the main difference is flexibility and price. An open mortgage gives you the flexibility to repay all or part of your mortgage throughout the term without penalty. But, given this flexibility, the interest rate is typically higher on an open mortgage than a closed mortgage. 

A closed mortgage does not give the option to prepay your mortgage without certain restrictions or prepayment penalties. Prepayment penalties mean that your lender can charge extra fees for attempting to repay your mortgage early. The lender may have prepayment penalties because they risk losing money if you repay your mortgage early. A closed mortgage is an excellent option for anyone planning to stay put for the long-term or aren’t planning to put a lump sum payment toward their mortgage. 

What are the pros and cons of an adjustable-rate mortgage?

With any big decision you make, it’s always a good idea to weigh the pros and cons to determine whether you’re making the best possible decision for your finances and your lifestyle.

The pros of an ARM:

• Historically, adjustable-rate mortgages are less expensive over time
• If you decide to sell your home or need to break your variable rate mortgage contract, you’ll have fewer break penalties than if you had a fixed-rate mortgage
• Typically, you can switch to a fixed-rate mortgage at any time
• You may be in a better position to pay off your mortgage earlier if this is a financial goal

The cons of an ARM:

• Unknowns as far as interest rates go can mean you’ll pay more money if rates increase significantly 
• If you decide to switch to a fixed-rate mortgage at a later date, you may end up with a higher percentage

How do you know if an adjustable-rate mortgage is right for you?

Once you’ve acknowledged the potential pros and cons and which one outweighs the other, it’s time to consider whether it fits your specific situation. You can ask yourself five questions to determine whether an adjustable-rate mortgage is a suitable choice for you. 

1. Do you have a flexible budget?

Given the chance for interest rates to fluctuate when choosing a variable rate mortgage, you should always consider your budget. You likely won’t see much impact if you have the cash flow to switch things up month to month or annually. But, if you’re on a tight budget or live paycheck to paycheck, you should consider having a more set-in-stone fixed-rate mortgage. 

2. What is your risk tolerance?

Like any investment you make, it’s essential to understand what type of financial inconsistency you can stomach. If you are comfortable with the uncertainty and making higher-risk investments, you likely won’t flinch at adjustable-mortgage rates. But, on the other hand, if you don’t like to see your money go up and down without any clear vision of the future, it might not be the best fit for you.

3. What are the current market conditions?

Today, inflation is causing many Canadians to double and triple-check their financial decisions. For years, having a variable interest rate would have been highly beneficial. But now that interest rates are likely to rise due to the increase in inflation; many homeowners may feel the pinch. Being aware of what’s happening in the real estate market and economy, in general, is critical for any homeowner who will be choosing what type of mortgage they’ll need in the coming months.

4. What is the spread between fixed and variable?

Knowing what interest rates are like is essential, but it’s also important to note the spread between a fixed-rate and adjustable-rate mortgage to determine which option has better value. If the spread between interest rates is low, many people consider choosing a fixed-rate option. Whereas, if the spread between interest rates is high, an adjustable-rate mortgage can be beneficial. 

5. What is my time horizon?

Suppose you currently live in a home but plan to move or sell within the next few years. In that case, it may be worthwhile to consider an adjustable-rate mortgage because they have much lower penalty fees for breaking your contract early compared to fixed-rate mortgages.

To be clear: no one can predict what interest rates or the economy will look like in the coming years. You can do your best to assess the current market conditions and research what expert economists predict, but at the end of the day, those are just that — predictions. Trust your gut and make the decision based on what works best for your personality and budget.

Adjustable-mortgage rates can be beneficial if you stay the course

At the end of the day, if you do choose an adjustable-rate mortgage, do your best to stay the course throughout your term. First, although there is an option to switch to fixed-rate if things get bumpy, you’ll almost always guarantee a higher interest rate than you could have obtained otherwise. Second, if you are worried about paying unknown amounts at a higher rate, make sure that you always have a household emergency fund to balance the increase and protect your finances.

Before making your final choice, consider speaking with a mortgage professional, your real estate agent, and a financial professional you trust. But, remember, when it comes to deciding whether an adjustable-rate mortgage is the right call, the only person who can make the decision is you.