An adjustable-rate mortgage (ARM) is a type of mortgage loan in which the interest rate and payment amount can fluctuate. This makes it similar to a variable rate mortgage in that the interest rate can change during your term, but is different in that the mortgage payment amount is not fixed. This means that if interest rates increase, your monthly payments will increase too.
This page will take a look at how adjustable-rate mortgages work in Canada, how they compare to fixed and variable mortgages, and why some borrowers choose to get an adjustable-rate mortgage over other mortgage types.
Adjustable-rate mortgages have a mortgage interest rate that changes based on the prime rate. Your ARM rate will be at a spread to your lender’s prime rate. If the prime rate increases, then your ARM rate will increase. An increase in interest rates will have the following effects on your adjustable-rate mortgage:
The first effect is that you’ll be paying more interest. When you make a mortgage payment, a portion goes towards mortgage interest while the remainder goes towards your mortgage principal. The mortgage principal balance is how much you owe. If you need to pay more interest now that rates have risen, you will need to pay more money each month towards your mortgage to account for the larger interest portion of your regular payments.
What this means is that the amount that goes towards paying your mortgage principal balance remains the same, while the amount that goes towards your mortgage interest can fluctuate depending on current interest rates.
The main difference between a variable and adjustable rate mortgage is that the monthly mortgage payment of a variable rate mortgage is fixed, while adjustable rate mortgages have a monthly mortgage payment that can change. This has an impact on how your mortgage principal balance is paid.
For variable rate mortgages, an increase in prime rates will also result in an increase in your mortgage rate. However, your monthly mortgage payment remains the same. This means that the amount of money that can go towards paying your mortgage principal will decrease, to account for the larger mortgage interest due. As interest competes for the same amount of money being paid each month, there will be less money being paid towards your principal.
It’s possible for interest rates to rise far enough that your static variable-rate mortgage payment isn’t enough to cover even the interest portion of your regular mortgage payment. The interest rate that causes this to happen is called your trigger rate, and the trigger point is when your current principal balance starts to be larger than your original principal balance at the beginning of your term.
Hitting your mortgage trigger point means that you now owe more on your mortgage than you started with. That’s from unpaid interest being added to your mortgage balance, which happens if your mortgage hits its trigger rate without you increasing your mortgage payment amount. Your static variable-rate mortgage payment can suddenly increase if your mortgage hits its trigger rate, which can be difficult on households when it comes to budgeting and planning. In November 2022, the Bank of Canada estimated that 50% of variable rate mortgages have already hit their trigger rate.
This issue doesn’t affect adjustable-rate mortgages, where the mortgage payment amount will change to keep the principal payments the same.
Borrowers might find it harder to budget for an adjustable rate mortgage as the mortgage payments can increase or decrease significantly. On the other hand, adjustable rate borrowers will benefit by keeping their mortgage amortization the same, allowing for their mortgage to be paid off on time.
A variable rate mortgage is similar to a fixed rate mortgage where the monthly mortgage payment is the same, which makes it easier to budget for. There won’t be any unexpected increases to the required payment amount partway through your term. In exchange, it may cause you to fall behind on your mortgage amortization if interest rates increase, which can cause an increase in mortgage payments for your next mortgage term when it’s time to renew your mortgage in order to keep your amortization on track.
|Variable Rate Mortgages||Adjustable Rate Mortgages|
|What Changes?||Both Interest and Principal Payments Changes||Interest Payment Changes, Principal Payment is Fixed|
Scotiabank's Flex Value Mortgage is an adjustable-rate mortgage. It's offered as either an open or closed mortgage for a 5-year term. The interest rate and payment will reset each time Scotiabank's prime rate changes. Features include being able to convert your adjustable-rate mortgage into a fixed-rate mortgage at any time without mortgage penalties, as long as the new term is longer than your remaining term. You can prepay up to 15% of your original principal or increase your regular payment by up to 15% for the closed adjustable-rate mortgage, while the open mortgage option includes more flexibility such as prepaying any amount at any time.
As of November 2022, Scotiabank's posted adjustable mortgage rate was Prime + 0.20% for the closed 5-year Flex Value mortgage and Prime + 3.30% for the open 5-year Flex Value mortgage.
Let’s say that you currently have an adjustable mortgage rate that is Prime + 0.20%. This means that your mortgage rate is your lender’s current prime rate, plus 0.20% on top of that. To see how changes in the prime rate can affect your monthly mortgage payment, let’s consider a $500,000 mortgage with a 25-year amortization.
If the current prime rate is 5.95%, then your adjustable mortgage rate will be 6.15%. If the prime rate increases by 0.50% to 6.45%, then your adjustable mortgage rate will now be 6.65%. The effect this will have on your mortgage payment is:
A 0.50% increase in the prime rate will increase your monthly mortgage payment by $100 for a $500,000 mortgage. This example assumes that the principal balance is $500,000 in both cases, which would only be the case at the very beginning of your term.
The Bank of Canada conducted a series of rate hikes in 2022 in response to Canada’s high inflation rate that brought prime rates to levels not seen since 2008. At the start of 2022, the prime rate in Canada was 2.45%. Nearing the end of 2022, the prime rate in Canada was 6.45%. That’s an increase of 4.00% in one year!
This can have a noticeable impact on households that have an adjustable rate mortgage. Based on the same example of a $500,000 mortgage with a 25-year amortization, and assuming that no prior payments have been made:
The increase in prime rates this year would have increased a $500,000 adjustable rate mortgage payment by roughly $1,107 per month! That’s a significant amount that can be hard to budget for.
Adjustable mortgages offer other benefits besides having a constant amortization. This includes:
The first advantage of adjustable mortgages are their more gradual payment changes. Each change in the prime rate would be in effect for your next scheduled mortgage payment. In comparison, a variable rate mortgage would require you to catch up to your scheduled amortization at renewal with a larger mortgage payment. This makes adjustable rate changes more gradual compared to the shock that a variable rate mortgage might bring at renewal, if rates are still elevated.
The second advantage is that adjustable mortgage lenders may offer you the ability to convert to a fixed mortgage rate at any time. This lets you lock-in your mortgage rate if you think rates will continue to rise in the future. If they don’t, and rates fall instead, then you’ll benefit from a lower mortgage rate and a smaller mortgage payment.
The third advantage would be the lower mortgage penalties associated with adjustable rate mortgages. ARMs often have a mortgage penalty that is just 3 months’ interest, rather than an interest rate differential (IRD) seen with closed fixed rate mortgages.
Adjustable mortgage rates are a great way to potentially save money on your monthly mortgage payments, but they also come with certain risks. To determine if an adjustable rate mortgage is right for you, consider the following factors:
Your current financial situation: You’ll want to make sure that you can actually afford the mortgage payments if rates increase. An adjustable rate mortgage should only be considered if you have enough savings available to cover any increases in payments or if your income level can support higher payments.
If you are in a good place financially and don’t anticipate any major changes in your income or expenses, then changes in an adjustable rate mortgage might not significantly throw off your budget. However, if you are financially unstable, or if you don’t have much breathing room in your budget, then you might want to avoid an ARM and consider a mortgage with a fixed payment instead.
Your tolerance for risk: An adjustable rate mortgage is more risky than a fixed rate mortgage as your interest rate and monthly payment can change over time. If you’re not willing and able to pay more money in interest if rates rise, in exchange for the possibility of saving money if rates fall, then the risk of an ARM might not be for you.