Essential Knowledge Series
Everyone knows there are multiple different mortgage products Canadians can choose from. So much so that sometimes it can get confusing. One of the most debated, and arguably confusing mortgage options is the static, variable rate mortgage.
What is a static, variable-rate mortgage (SVRM)?
A static, variable rate mortgage is a mortgage that allows you to have all of the benefits of an adjustable, variable rate, with an added benefit of never having your payment change. In other words, you have the fixed-rate feature of your payment remaining the same but have the ability to pay interest according to the prime rate.
There are many pros and cons to this mortgage type, and with the recent rate increases, there has been some confusion on how these products work. This post will look to guide you to determine how your current SVRM is functioning and if a SVRM is correct for you.
Features of a SVRM
There are essentially two major features to this mortgage product. These include your payment remaining the same and being able to follow the lender's prime rate.
Payment remaining the same (static)
Ability to follow the lender's prime rate
1. Payment remaining the same (static)
As a homeowner, this static payment can be a huge benefit. Having a consistent payment will allow a person to budget accordingly and know how much will be coming out of their bank account each and every month. You might be wondering, "Alex, if the interest rates increase, and my payment doesn't change, what is the catch?"
That is a great question. The short answer is that as interest rates increase, you will have more of your monthly payment going towards interest and less towards the principal. As a result, your amortization will increase. Let's give you an example. Let's imagine you have a $500,000 SVRM with a $2,200 payment. We'll assume an interest rate of 3.00%. Generally speaking, 60% of the mortgage payment at the start of a 25-year mortgage will go towards interest, and 40% will go towards the principal.
If your interest rate goes up to 3.50%, your $2,200 will remain the same but the 60% will increase and your 25-year amortization will also increase. Every mortgage is different so I won't go into specific details of the dollar amounts, but just know that there is a consequence of your mortgage payment not increasing.
From a financial planning standpoint, this is a tricky situation. Mathematically speaking, having your amortization increase every time your interest rate increases is a bad idea. If you're looking to retire in 25 years and now your mortgage won't be paid off for another 30 years, you could be in trouble.
However, in certain circumstances, this option could be beneficial. Two of the most obvious examples would be someone who is on a tight budget in the short term and an investor. The person on a tight budget is looking to stay within their means and reduce uncertainty. In this case, the static payment would be optimal. Likewise, the investor who rents out their property likely has a strict budget and doesn't want to go into a negative cash flow on a property.
In either of the above cases, the payment remaining the same is a key component of their cash flows. This is why I say it all depends on the person's situation. Does it make sense for someone who is ok with payment fluctuations? No. But that doesn't mean it can't work for someone else. Either way, it's important to talk with your mortgage professional and complete the calculations to see if it's the right decision for you.
One other thing to mention - if interest rates decrease, your payment doesn't decrease with them. Your payment stays the same but your amortization will decrease. This is great for paying off your mortgage sooner but won't help you if you're on a tight budget and looking for relief.
2. Ability to follow the lender's prime rate
As the name states, this is still a variable-rate mortgage. The interest you pay will be affected by increases and decreases in the prime rate. As such, unlike the person who is on a tight budget and looking for their payment to decrease, the benefit of a rate decrease will be a decrease in your amortization.
This happens because the interest component of your mortgage payment will decrease with every rate decrease. For most people who like to set their payment and forget it, this can be huge. They won't notice any change in payment but they may pay off their mortgage 1,3, or more than 5 years earlier. On the opposite end of that argument is what I touched on in the first point. If rates increase, the interest portion of your payment increases which lengthens your amortization. You might be thinking, "Alex, this isn't so bad because over the life of the mortgage this might even out with rates going up and down". Fair enough. But in the fine print of your mortgage contract is something called a Trigger Rate.
The terms and conditions around this trigger rate will be different for all lenders, but generally speaking, they all have the same effect. If your rates increase to a point where your amortization has extended past the maximum amortization possible, you're in for a surprise. Either the lender will force you to make some sort of pre-payment to reduce the amortization. Or, your payment will increase. Not much of a static payment anymore.
Let's hope we don't see rates increase enough for people to reach their trigger points, but in 2022, anything is possible with inflation running rampant and the housing market being so volatile.
Either way, when looking at your mortgage, you should always talk with your mortgage professional and determine your best course of action. I like to go back to George Washington's quote when it comes to choosing your options carefully and avoiding regretting them later. “It is better to offer no excuse than a bad one.” Never, and I mean never, think you aren't subject to mistakes and errors. Someone before you has made those mistakes and you might as well use their knowledge to avoid them altogether.
Questions/Comments?
Give us a shout in the comment section or find our contact details on the main page of our website at www.triedandtruemortgages.ca
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