Adjustable-rate mortgages (ARMs) are gaining popularity because the interest rate can vary. However, they are different from fixed-rate mortgages, where the interest rate stays the same, or variable-rate mortgages. The last two types of mortgages have the same payment regardless of the interest rate. Continue reading to discover how you could be affected by the rise of the adjustable-rate mortgage.
An ARM has a rate that changes and a payment that goes up or down. Even though the two terms are used interchangeably, it’s essential to determine whether your mortgage is of the variable or adjustable rate type.
Understanding how to pick the best product for your situation means knowing the difference between adjustable-rate and fixed-rate mortgages. It’s also important to know how interest rates affect these ARMs and how to choose the best product.
What Are Adjustable-Rate Mortgages, and How Are They Different from Fixed-Rate Mortgages?
Adjustable-rate mortgages (ARMs) don’t have a fixed rate that runs through the term. These mortgages fluctuate based on each bank’s prime rate, which is, in turn, influenced by the Bank of Canada’s overnight rates. They are also different from variable-rate mortgages, which take into consideration the interest rate, but the payment stays the same.
As the name implies, a fixed-rate mortgage has an interest rate that stays the same throughout the term. It’s important to remember that payments stay the same with both variable and fixed-rate mortgages.
With a fixed rate, the interest rate is locked in, so you know what the outstanding loan will be on the renewal day if you make all your payments. With an ARM product, the interest rates make a difference. For example, when the rates increase, you pay more interest and less off on principal. The result is that the amortization period can be affected.
Those who opt for a fixed-rate mortgage have peace of mind because the interest rate is set, and the monthly payments are predictable. With an ARM mortgage, you can take advantage of falling interest rates, and you might pay less interest overall. Plus, the payment amount can float with the interest rate.
How Do Interest Rate Changes in Canada Impact ARMs?
The Bank of Canada (BoC) is responsible for the target or overnight lending rate. Banks use this term for the interest rate they charge other banks to cover quick, daily, short-term transactions. This is how banks put together the formula for the rate they charge their customers, which is termed the prime interest rate.
- ARMs are tied to this prime lending rate. So when the banks raise their interest rates, more of an adjustable-rate mortgage goes toward interest, which means you’re paying less off on the principal.
- When these rates increase, your amortization can go up as well. That means it can take longer to pay off your mortgage.
Your mortgage payments can increase when the interest rate goes up on an ARM. Remember, the situation works in reverse when the rates go down, meaning more of your mortgage payment goes towards the principal you owe on the loan. You also need to remember that an ARM mortgage has a payment rate that goes up or down with the interest rate.
What Factors Should Canadian Borrowers Consider When Choosing an ARM?
One of the big things to remember here is that the payment amount can change with an ARM mortgage.
Falling interest rates due in mid-2024 can be a good time to consider one of these mortgages. Remember, lower payments will follow these lower rates for one of these products.
According to the Financial Post, there are some other things that borrowers should look out for before they consider one of these mortgages, including:
- Traditional lenders make it hard to qualify with strict debt ratio limits.
- They also require high credit scores to get the best rates and keep 30-year amortizations off most of their offerings.
- Properties valued over $1 million are not eligible for these types of mortgages.
Borrowers looking to lower their payments should watch the Bank of Canada for an interest rate cut.
What Are the Potential Risks and Benefits of ARMs in the Current Canadian Economic Climate?
Keeping an eye on the interest rates can make or break one of these mortgages. If the rates go up high enough and you want to break the mortgage before the term ends, most come with a reasonable 3-month interest penalty. However, consumers must watch out for lenders basing those penalties on your primary instead of the discounted rate.
Property owners who want to transfer one of these mortgages to a new property should know that many of these ARMS don’t allow this. According to The Financial Post, some even require you to close old and new deals on the same day.
Potential borrowers need to be aware that increasing payments can strain your budget when the rates go up.
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