Variable Mortgage Rate in Canada: How It Works and Strategy

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The Variable Mortgage Rate: How It Works and Strategy

The variable mortgage rate is an option that appeals to borrowers willing to accept some uncertainty in exchange for a generally lower initial rate and a less costly prepayment penalty. Unlike the fixed rate, which is locked for the term duration, the variable rate evolves throughout the contract based on the Bank of Canada's monetary policy decisions.

The Link to the Prime Rate

The variable rate is directly linked to the lender's prime rate. This prime rate is itself largely determined by the policy rate (overnight rate target) set by the Bank of Canada. When the Bank of Canada raises its policy rate, lenders increase their prime rate, and vice versa. The variable rate is generally expressed as "prime minus X%". For example, if the prime rate is 5.95% and your discount is 0.80%, your effective variable rate is 5.15%. The discount (or premium) is set at the time of signing and remains constant for the entire term duration.

Prime Rate: A reference rate established by each Canadian financial institution, generally based on the Bank of Canada's policy rate plus a standard margin of 2.20%. It serves as the basis for calculating variable mortgage rates and home equity lines of credit. Major Canadian banks typically adjust their prime rate within days of a policy rate change.

Fixed Payment Versus Adjustable Payment

In Canada, variable-rate mortgages come in two variants with very different implications for the borrower. The fixed-payment mortgage maintains the same monthly payment amount regardless of rate fluctuations. When rates rise, a larger portion of the payment goes to interest and a smaller portion to principal repayment. Conversely, when rates fall, more principal is repaid. The main risk is the trigger point, where interest exceeds the monthly payment. The adjustable-payment mortgage, on the other hand, modifies the payment amount as soon as a rate change occurs. If the prime rate increases by 0.25%, your payment increases immediately to reflect the new rate. This approach ensures that the planned amortization is always respected, but it exposes the borrower to budget fluctuations.

Strategic Advantages of the Variable Rate

Generally lower initial rate than the fixed rate, meaning interest savings from the first month if rates remain stable or decrease.
Prepayment penalty limited to three months' interest, providing considerable flexibility to sell, refinance, or switch lenders.
Favorable historical performance: the variable rate has cost less than the fixed rate in the majority of Canadian economic cycles.
Immédiate benefit from Bank of Canada rate cuts, without having to wait for term renewal.
Ability to convert to a fixed rate mid-term with most lenders, providing a safety net if rates rise in a sustained manner.

When Is the Variable Rate the Right Choice?

The variable rate suits borrowers who have sufficient budget margin to absorb payment increases, who have good financial risk tolerance, and who may plan to sell or refinance before the end of the term (thus benefiting from the lower penalty). It is also wise when rates are high and decreases are anticipated, as the borrower will benefit from reductions as soon as they occur. An AMF-certified mortgage broker in Quebec can run a simulation comparing the total cost of a fixed rate and a variable rate under different rate scenarios, allowing you to make an informed decision based on concrete numbers rather than assumptions.

Frequently Asked Questions

How does the variable mortgage rate work in Canada?

The variable rate is indexed to the lender's prime rate and expressed as prime plus or minus an adjustment (e.g., prime - 0.80%). When the Bank of Canada changes its policy rate, lenders adjust their prime rate, which causes your mortgage rate and, depending on the loan type, your monthly payment to change.

What is the difference between fixed payment and adjustable payment on a variable-rate mortgage?

With fixed payment, your monthly payment stays the same, but the principal/interest portion varies with rate fluctuations. With adjustable payment, your monthly payment changes immediately when the prime rate moves. Fixed payment offers more budget stability but carries the risk of a trigger point if rates rise too much.

What is the trigger point on a fixed-payment variable-rate mortgage?

The trigger point occurs when interest rates rise enough that your fixed payment no longer covers the full interest owed. At that point, the lender may increase your payment or negative amortization begins. Since 2022, many Canadian borrowers have reached this point following rapid Bank of Canada rate hikes.

Is the variable rate really cheaper than the fixed rate over the long term?

Historically, studies show that the variable rate has cost less than the fixed rate in approximately 80 to 90 percent of 5-year periods in Canada. However, past performance does not guarantee future results, and certain periods of sustained rate increases can make the variable rate more expensive.

What is the penalty for breaking a variable-rate mortgage?

The penalty is almost always three months' interest, without the IRD calculation applicable to fixed rates. This is a major advantage of the variable rate, as the penalty is generally much lower, providing more flexibility if you need to sell, refinance, or switch lenders before the end of the term.

Is the variable rate suitable for a first-time buyer?

It depends on your profile. If you have good budget margin (ability to absorb a 1 to 2 percent increase in your rate), adequate risk tolerance, and a property horizon potentially shorter than 5 years, the variable rate can be advantageous due to its lower penalty and generally lower initial rate. Consult an AMF-certified mortgage broker for a personalized analysis.