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The YVR Real Estate & Mortgage Show Episode 37 - Variable Rate Mortgages: What Do They Do & Mean?


We're going technical today guys, we're talking about variable rate strategies. This is something that pretty much every person in Canada and that has a mortgage should listen to because we'll talk about everything from what a variable rate mortgage is, prepayment penalties and what they mean, what different lenders offer strategies, you name it, you're gonna get the full mother load here today about variable rate mortgages.


Apparently up to 74% of Canadians either would take or currently hold a fixed rate mortgage. Obviously there is benefit to fixed rate, it's conservative, but there's a ton of benefit to variable right now.


The average Canadian does take a fixed rate mortgage, my perception based on helping thousands of clients at this point with financing is, Canadians by nature are conservative. When we talk to our American counterparts, they're always quite surprised at how many of our clients go with an option that could have such as a big downside when there's so much benefit of the variable rate solution. Our default rates in Canada are insanely low.


What is a variable rate?

The biggest difference from a variable to a fixed rate is your rate can change during your term. If you have a five year mortgage, five year term, your variable rate mortgage could change a number of times in this year. For example, we've seen the variable rate drop more than a couple times. That's probably the biggest difference is your rate can change. The total amount of interest alone could go up or go down. The principle of course, would go up or down correspondingly. So it's just not in a fixed term.


When clients think, my rate could change, that's kind of scary for them. I think that's where the conservative nature comes in, is the fact that my rate could go up. That means payments could go up. I think that's probably the biggest reason why people go with the fixed rate mortgage, because of the certainty that their payment is going to remain the exact same.


Why would rates go up? When would they go up or down?

So the Bank of Canada, I believe they meet eight times a year and they obviously look at our economy, the health of the economy, and they'll justify if they want the Bank of Canada key rate to increase or decrease. So, if the Bank of Canada decides to increase interest rates, typically within a week to two weeks, we'll see the banks like our banks, TD Scotia, RBC, they will all follow suit. So if there's a point to 5% increase at the Bank of Canada, we will typically see our banks raise prime rate. Now, variable is tied to prime rate. Currently, the prime rate with most institutions is 2.4% or 5%. So when you get a variable rate mortgage, let's say it's 1.8%, your rate would be basically justified as a discount off of prime. So if primes 2.45% and you're getting a 1.8%, your rate is prime -0..65%. That's how your variable rate would basically stay in place. If prime changes in six months, your rate stays at prime -0.65% and it will fluctuate up or down. Yeah, that's a good explanation on that point, we should also make a point to say while we're talking about variable rates, another form of a variable rate loan on a mortgage is a home equity line of credit. It's important to note most variable rate mortgages and home equity line of credits that plus or minus what we call a discount, or an increase that never changes. So you take a five year term of prime minus .65%, or point .65%, that .65, will never change. That will stay with you for the life of the term. Yeah, that makes a lot of sense.


Why would the interest rates adjust is a really key point in regards to what someone could/should be looking forward to this year would be the perfect example. Obviously, it's something very unique, COVID happened. It was a pandemic, the first time we're dealing with something of this nature in modern day lending history. We're in a position where, short and sweet, people aren't spending money or making money. That's not a good thing for our economy and The Bank of Canada is going look to try to get money moving. When they do that, the banks follow suit typically and reduce their prime rate which means your interest rate goes down. So what we saw in March, the Bank of Canada made a number of consecutive emergency decisions where they actually looked at the economy and said, we are looking at a circumstance where the economy could be floundering. Let's stimulate the economy and get people to continue to spend money and save and make money. When something happens, a world event, an economic event, or just overall where people aren't making spending money in the economy, we see that happen. That's where interest rates go down.


Everybody always wants to lowest rates, human nature, right? Everybody wants a lowest rate which is why right now a lot of people are more comfortable taking the variable because it's immediate savings. We'll get into some of the benefits of the variable, but it's lower than the fixed currently. So the day that your mortgage funds, you're saving money compared to that fixed rate mortgage. But if you put yourself in someone's shoes two years ago, or even a year ago, fixed rates were actually lower than variable for a little while variable rates were higher. So as much as there's more flexibility around a variable, there were a lot of people locking into the fixed because everybody wants that lower interest rate. We're actually starting to see fixed rates get pretty close to the variables. Some variables are going out at 1.7%. There's fixed rates as low as kind of 1.99%. It's significant on a big chunk of money that you're borrowing. One of the biggest things that we get is when there is a rate change. Typically when there's a rate drop, we don't actually see the lenders follow that same amount. What I mean by that is if the Bank of Canada decides to drop .5%, we haven't always seen the banks match that. Typically, it takes two to three days. It's not always the exact same.


Compounding Periods

So there are there's typically two compounding periods in a mortgage, it's usually compounding monthly or semi-annually.


Semi-annually is typically what we see that I would say pretty much every fixed rate mortgage would be calculated at. A lot of variable rate mortgages are compounded semi-annually to but there are a lot of lenders that are compounding monthly. Typically unsecured debt is actually compounding daily, which is significantly more so if your mortgage is compounding monthly opposed to semi-annually. If you had a $250,000 mortgage and it compounded monthly, you would pay roughly your total interest costs in 25 years and it would be 180. $88,441, if you had that same mortgage compounding semi-annually, you would pay $186,204 in the same time period of 25 years. So that's a difference of $2,237 over 25 years. If you're looking at the same variable rate from lender x and lender y, and one's compounding monthly, well, you should probably go to the one with the compounding semi-annually.


Pre-Payment Penalties

There are a lot of circumstances that happened in people's lives that caused them to break a mortgage including divorce, deaths, moving, relocating, restructuring, refinancing, switching terms, and honestly I could go on and on. We get a call pretty much every single day about a different unique circumstances. S lot of people don't make it to the end of the term, I think the average timeline that we saw was at 38 months. It's pretty important to know what the cost is to get out of your term. Most people don't know what that is and most banks can't explain it.


I think the biggest issue is fixed rate penalties. There's literally no way to quote a penalty down the road for a fixed rate. It's based on interest rates at the time and your discount but there's like four different ways to calculate it. There's no way to tell someone if you broke your mortgage in three years, this is how much it's going to be because it depends on rates at that time. Nobody knows where that's going to be. That's the scariest part about a fixed rate. So anyone that takes a fixed rate, we just blatantly tell them that you know if you're breaking this mortgage you could have a pretty dramatic penalty. The biggest driver behind people taking a variable is the flexibility in the product. The penalty is three months of interest. On a $500,000 mortgage, currently, you'd probably be paying about $2,000 to get out of that product at any time. It's not all about moving. As an example, we saw rates dramatically dropped over the last six months. We contacted every single one of our past clients to show them an opportunity to save money. A lot of people that run fixed rates, they're restricted from doing that. It's breaking the mortgage to refinance to lower your interest rate to pull equity out. There's a lot of scenarios where it can rise. That is basically the concept of the variable and why people go that route for the penalty. From a bank's perspective, they're looking out for them and the profitability of a company. For them to sell a mortgage product, these are sales people selling products for that institution. It makes a lot more sense it from a business perspective, if you're a bank, you would want to sell fixed rates because you're you're essentially creating certainty of income for your company for the future. I think the best way to put it is when you're a variable rate client, you are the one in control of your destiny, you can leave whenever you want, and their penalty is not going to change anything just going to keep going down because you're going to keep paying that principle down.


If you're caught in a fixed rate mortgage, it's not a poor decision to make, it's just that there's a lot of reasons to go with a variable rate solution. The Bank of Canada literally came out mid June or July and they said that they predict interest rates to be low for two to three years. There's different lenders, different penalties, and different prepayment costs.


When Do I Lock In A Rate?

That question comes down to it's a personal situation. In some circumstances there's been a really valid point where someone's been concerned because let's say one partner is pregnant and having a child and they're sure that there's not going to be income for a period of time. If they fully and honestly believe that they are at a rock bottom situation in regards to the market, then again, personal feelings aside, then it's a good time for you if you feel like but there's no guaranteed perfect time. That's like trying to time the real estate market, when is the right time to buy? There is no perfect time to buy. The perfect time to buy, realistically, was 10 years ago. We're at historical low fixed rate mortgages.


*I had a client who was actually kind of a unique structure. They bought a house about six months ago, right at the beginning of COVID. They wanted to go with a fixed rate but we talked about the projections and what was likely to happen with interest rates. They went variable and they are now just converting into a fixed and they're probably saving about point 5.69% when they compare the fixed rate six months ago to what it is right now. SThat solution actually worked for them. We talked about projected rate drops and they're locking in now because they're comfortable.


You don't just have to take what your bank is offering you. It's also important to know that you're not locking in at what your current rate is. We have clients that took a variable rate three years ago and they're currently sitting at around 1.4% interest rate right now. They had such a big variable rate discount, they're thinking let's lock in at 1.4%. Unfortunately, it doesn't work that way. You're locking in at what the best fixed rate is for the remaining years of your term. If you've got two years left, you're going to get offered the best fixed rate, the best two year fixed rate from your lender.


We've got a unique program for our clients that are in a variable rate mortgage. Basically, we'll we'll find a way to make sure you get the guaranteed best solution as opposed to just locking with whatever is offered by that institution.


Payments

We have some unique payment programs with some lenders, where they have what I like to coin as frozen payments. This means whether or not the variable rate, the Bank of Canada, or prime increases or decreases the amount of principal and interest that you pay would be what fluctuates as opposed to the payment amount. So the same amount of money is going to come out of your account every single month. You don't have to stress about it and think about it. The amount of principal and interest that comes out would go up or down if prime went up or down. It's a really good product for someone that likes the concept of variable but maybe they're scared of the payment piece. If there was say a interest rate increase, your payment stays the same, you start paying more interest in less principal with some people might not want to do or maybe they can afford the increased payment, the bank will typically reach out to let you know what happened. They'll give you the option to adjust your payment if you want to.


I hope you like listening to a bunch of nerds that like talking about mortgages. You're not gonna find too many people out there who talk about mortgages as much and as frequently as we do. So if you are currently in a mortgage and you feel like you need that checkup, then you should be reaching out to us so we can have a look and make sure you're in a good situation. There's no cost for it. We'll take care of you.


Thanks so much for tuning in to this week's episode. If you loved it, I hope you did, make sure to leave us that five star review on Apple podcasts. Send us a email if you have any questions by visiting our website below!


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