As brokers, were always asked about the difference between fixed and variable rate mortgages. Today Id like to address the difference between a variable rate, and the less frequently discussed, adjustable rate mortgage. I will also inform you of the key issue which may cause your mortgage to transform itself into a negative amortization (NegAM) and explain how you can avoid this from happening to you.
Adjustable rate mortgages are lesser known and seldom offered as many of the major financial institutions in Canada typically offer variable rate mortgages instead. Adjustable rate mortgages are however more popular on the broker side of the industry and are usually offered by lenders that offer mortgage products only.
So what exactly is a NegAM?
Well, its basically a mortgage that keeps on growing. Imagine taking on a $300,000 mortgage with a 5yr variable rate option at 2.0% and a 25yr amortization. Naturally you would think that after 5 years of regular monthly payments you would have a balance of around $251,000 and 20 years left on your mortgage; that would be the case if rates didnt rise during your 5yr term. But what if interest rates did rise during your term and your monthly mortgage payment remained unchanged? I can almost certainly tell you that your mortgage balance would be higher than that noted on your mortgage commitment. Its unfortunate, however, you just became a victim of NegAM. Most people wont even notice this is happening to them until its too late or when their mortgage comes up for renewal. For this reason alone, many Canadians end up choosing to go with a fixed rate mortgage.
How do I know if this is happening to my mortgage?
For those of you with an adjustable rate mortgage youre safe! For those of you with a variable rate mortgage, youre safe for now. That is until the Bank of Canada increases the prime lending rate which hasnt been done in quite some time.
Heres how it works . When the prime lending rate starts to increase, variable rate payments tend to remain unchanged. This could be an excellent feature in a declining interest rate environment as more of your payment will be applied directly to your principle, thus accelerating the repayment of your mortgage and potentially saving you thousands of dollars. This is definitely not the case when interest rates start to rise though In fact, the complete opposite will happen and your mortgage will begin to transition itself into a NegAM. The affect of this could have a significant impact on your retirement and ability to pay off your home. Adjustable rate mortgages on the other hand will adjust to changing interest rate conditions and will keep your amortization in check as your payment will modify itself to reflect the increase or decrease in your rate.
So how do I protect myself?
First things first, youll need to find out if you have a variable or an adjustable rate mortgage. If you have either one of these products, youll need to pay close attention to Bank of Canadas (BoC) interest rate movements more so if youre in a variable rate scenario. Secondly, pay close attention to those letters your lender sends you each time there is a change in rates. If you notice that your payment seems to be the same after an interest rate hike announcement, you may want to call your lender and advise them to increase your payment to reflect your original amortization schedule – otherwise, less of your payment will be applied to your principle forcing your amortization to extend. Its best to keep track of your mortgage by following your amortization schedule which can be requested from your lender anytime.
Although variable rate mortgages are common and liked by many of us, they could cost you dearly in an interest rate rising environment. Thankfully, one of the best features that both of these products offer is the flexibility to switch into a fixed rate mortgage at a moments notice. So remember, if youre in a variable or adjustable rate mortgage, make sure to monitor them regularly. The good news is that DoYourOwnMortgage.com will keep you posted and up to date when it comes to changing interest rate market conditions. So make sure to check in with us regularly and dont forget to like us on Facebook!
Lionel Khoury, AMP