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Variable Mortgage Interest Rates (ARM)
Many homeowners shy away from a variable interest rate product when it comes to their mortgage. The main reason homeowners stay clear of variable rates, is because of the interest rate risk that is present. Variable interest rates on your home mortgage product can change in either direction during the mortgage term. The variable rate may increase or decrease, and as a result the interest you pay on your mortgage payment will follow in that direction. There are two main components of a variable interest rate on your home mortgage; the Prime Rate and the interest rate spread.
The first part of the variable rate mortgage product is the Prime Rate. The Prime Rate is set by the Bank of Canada (BoC). Every so often the government changes the Prime Rate. If the Prime Rate increases, so will your home mortgage rate. If Prime Rate decreases, so will your mortgage rate. The key factor that affects the direction of Prime Rate is the economy. If the economy is booming and inflation is rising too fast, the BoC will increase the Prime Rate to slow down spending. If the Canadian economy is struggling, the BoC will lower the Prime Rate to increase spending and the help the economy recover.
The second major part of the variable interest rate home mortgage product is the spread. The lender will usually have an interest rate spread that will make your overall mortgage rate higher or lower than the Prime Rate. For example if the Prime Rate is 3% and the spread is plus 1%, your mortgage rate is 4%. But if the Prime Rate is 3% and the interest rate spread is -.5%, your mortgage rate is 2.5%. The key factor that determines the interest rate spread on your home mortgage rate is risk. If the housing market is booming and home prices are increasing, then there is low risk and you will have a favourable interest rate spread on your mortgage. But if the housing market is crashing and house values are declining, then you will have an unfavourable spread. However once you have selected an interest rate spread for your mortgage, it will not change during the mortgage term (unlike the Prime Rate).
Fixed Mortgage Interest Rates
Fixed rates are popular with Canadian homeowners because of the reduced risk. Fixed interest rate mortgage products do not have interest rate risk. The mortgage rate you have throughout the term of the mortgage is the same. Although the lack of risk seems favourable, there is also lack of gain if interest rates decrease during the mortgage term. For example in 2009 Prime Rate dropped to 2.25%…the lowest it has been in recent Canadian history! Many homeowners had a fixed mortgage product and had a locked-in rate of around 4%. In these times, mortgage owners with a fixed rate product paid much more in interest compared to variable rate mortgage owners. So before you immediately choose a fixed rate mortgage product over a variable rate product, you may want to think about the direction interest rates are heading in the future, as it can save you interest paid on your home mortgage.
The mortgage term on the product is the length of the mortgage agreement. The longer the borrowing term, the longer the agreement is with the mortgage lender. Once the term (or contract) has concluded, the borrower must either repay the entire mortgage amount or renew the mortgage for another term. The longer the mortgage term is, the more interest rate risk is present to the mortgage lender (and on the flipside, the less interest rate risk is present to the mortgage borrower). For example, interest rates are more likely to change over the course of 10 years compared to 1 year. As a result, fixed mortgage rates for 10-year termed mortgage products are much higher than 1-year termed mortgage products. So although a longer mortgage term reduces the interest rate risk for the borrower, it also increases their cost of capital on their mortgage product.