Mortgage Basics

What is an Adjustable-Rate Mortgage (ARM)?

What is an Adjustable-Rate Mortgage (ARM)?

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    Variable mortgages have been a popular choice among Canadians for several reasons. They have historically saved homeowners money on the interest portion of their mortgages. When interest rates hit all-time lows, many Canadians turned to variable mortgages as a way to navigate the stricter mortgage qualification requirements imposed by the stress test. 

    Many homebuyers opted for a variable rate to save money over fixed rates as the benefits outweighed the risks associated with variable mortgages at the time. Borrowers could potentially qualify for larger loan amounts or more affordable monthly payments by choosing a variable rate.

    In Canada, there are two types of variable mortgages: adjustable rate (ARM), which has payments that adjust with changes to the prime rate and variable rate (VRM), which has fixed payments that do not adjust with changes to the prime rate. This post provides an in-depth look at ARM mortgages and how they work, helping you decide if it’s the right mortgage solution for your circumstances.

    Key Takeaways

    • An adjustable-rate mortgage (ARM) has a fluctuating interest rate where monthly payments change with your lender’s prime rate. 
    • ARMs provide the potential for immediate cost savings if interest rates fall compared to fixed-rate and VRM mortgages.
    • ARMs are suitable for those that can withstand higher payments since higher payments are realized immediately if interest rates rise.

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    What Is an Adjustable-Rate Mortgage (ARM)?

    An adjustable-rate mortgage (ARM) is a type of variable mortgage that sees mortgage payments fluctuate going up or down based on changes to the lender’s prime rate. The principal portion of the mortgage remains the same throughout the term, maintaining your amortization schedule. 

    If the prime rate changes, the interest portion of the mortgage will automatically change, adjusting higher or lower based on whether rates have increased or decreased. This means you could immediately face higher mortgage payments if interest rates increase and lower payments if rates decrease. 

    ARM vs VRM: Key Differences 

    ARM and VRMs share some similarities: when interest rates change, so will the mortgage payment’s interest portion. However, the key differences lie in how the payments are structured. 

    With both VRMs and ARMs, the interest rate will change when the prime rate changes; however, this change is reflected in different ways. With an ARM, the payment adjusts with interest rate changes. With a VRM, the payment does not adjust, only the proportion that goes toward principal and interest. This means the amortization adjusts with interest rate changes.

    ARMs have a fluctuating mortgage payment that sees the principal portion remain the same while the interest portion adjusts with changes to the prime rate. This means your mortgage payment could increase or decrease at any time relative to the change in interest rates. This allows your amortization schedule to remain on track.

    VRMs have a fixed mortgage payment that remains the same. This means changes to the prime rate affect not only the interest but also the principal portion of the mortgage payment. As your interest rate increases or decreases, the amount going toward the principal portion of your mortgage payment will increase or decrease to account for changes in interest rates. This adjustment allows your mortgage payment to remain fixed. A change in your lender’s prime rate could affect your loan’s amortization and lead to hitting your trigger point and, eventually, your trigger rate, leading to negative amortization

    Payment Adjusts Yes No
    Principal Component Unaffected  Changes to compensate for changes in the interest component
    Interest Component Adjusts with prime rate changes Adjusts with prime rate changes 
    Amortization Unaffected Affected by prime rate changes
    Rates increasing Monthly payment increases – your cash flow decreases Amortization increases – it takes you longer to pay off your mortgage
    Rates decreasing Monthly payment decreases – your cash flow increases Amortization decreases – you become mortgage-free faster
    Trigger Rate Risk No Yes
    If the interest component is eating into your principal component, your balance and amortization will increase since payments remain unaffected.
    Trigger Point Risk No Yes
    You can owe more than your original mortgage at the beginning of your term if you don’t make additional prepayments.
    Renewal Risk No Yes
    If your mortgage balance and amortization have increased, you’ll have to prepay any extra balance and return the amortization to your original schedule.
    Payment Shock Risk Yes Yes
    When you renew at maturity, if the interest rate is higher.

    At renewal, with any ballooned mortgage balance from hitting your trigger point or trigger rate.

    At renewal, you’ll need to bring your amortization back down to its original schedule.
    Savings Pay Now / Save Now

    If rates increase, you’ll pay a bit more on your payment but stay on track with your amortization schedule.

    If rates decrease, you’ll free up room in your monthly cash flow.
    Pay Later / Save Later

    If rates increase, you could defer changes to your cash flow, especially when inflation may be high. 

    If rates decrease, you’ll reduce your mortgage amortization. 

    If rates decrease, you’ll free up cash flow at renewal by returning to your original amortization schedule or continuing with your remaining amortization to be mortgage-free sooner.
    Costs If rates increase, increasing payments can restrict your cashlfow. If rates increase, the build-up of interest payments can mean a much higher balance at renewal.

    If rates increase quickly, a refinance may be required to bring your amortization back to its original schedule.
    (Refinance rates are typically higher than renewal rates)
    Suitability Most suitable when rates have peaked and the difference between fixed and variable 5-year rates is not enough to lock into long-term rates. Most suitable for your primary residence when rates have peaked and you’re looking to become mortgage-free faster.

    Most suitable for your investment property when you’re looking to extend your mortgage interest over longer periods (to reduce your rental income). 

    How Fixed Principal Payments Impact Your ARM

    With an ARM, the amount that goes toward paying your mortgage principal remains the same throughout the term. This means that with an ARM, the portion of the mortgage payment that goes toward reducing your mortgage balance remains constant, reducing the amortization regardless of changes to interest rates. Since mortgage payments could change at any time if interest rates change, this type of mortgage may be best suited for those with the financial flexibility to handle any potential increases in mortgage payments. 

    Defining Your Mortgage Goals with an ARM 

    An adjustable-rate mortgage can potentially help you save significant money on the interest you will pay over the life of your mortgage. You would realize savings immediately, as falling interest rates would mean lower payments on your mortgage. 

    Additionally, adjustable mortgages have lower discharge penalty calculations when compared to fixed rates should you need to break your mortgage before maturity. An ARM may be a good fit if you’re a well-qualified borrower with the cash flow through your income or additional savings to weather potential increases in your budget. An ARM requires a higher risk appetite.

    Example: Adjustable-Rate Mortgage Performance in 2023?

    Let’s look at how an ARM performed in 2023 as prime rates changed with changes to the BoC policy rate. The table below illustrates how monthly mortgage payments would have changed on a $500,000 mortgage with a 25-year amortization and a 5-year term. 

    Over 2023, monthly payments increased by $154.07 ($3,564.04 – $3,409.97) from the lowest payments made at the beginning of the year to the highest payments made at the end of the year using changes to the prime rate.  

    Month BoC Policy Rate Prime Rate (Policy Rate +2.2%) Monthly Mortgage Payment
    January 4.50% 6.70% $3,409.97
    February 4.50% 6.70% $3,409.97
    March 4.50% 6.70% $3,409.97
    April 4.50% 6.70% $3,409.97
    May 4.50% 6.70% $3,409.97
    June 4.75% 6.95% $3,486.66
    July 5.00% 7.20% $3,564.04
    August 5.00% 7.20% $3,564.04
    September 5.00% 7.20% $3,564.04
    October 5.00% 7.20% $3,564.04
    November 5.00% 7.20% $3,564.04
    December 5.00% 7.20% $3,564.04

    How is an Adjustable-Rate Mortgage Expected to Perform in 2024?

    The table below illustrates the impact on monthly mortgage payments for the same $500,000 mortgage with a 25-year amortization and a 5-year term. We’ve used predictions for where interest rates may be headed in 2024 to forecast how an ARM could perform over the year. 

    Over 2024, monthly payments have the potential to decrease by $305.33 ($3,564.04 – $3,258.71) from the highest payments made at the beginning of the year to the lowest payment made at the end of the year using possible changes to the prime rate.  

    Month BoC Policy Rate Prime Rate (Policy Rate +2.2%) Monthly Mortgage Payment
    January 5.00% 7.20% $3,564.04
    February 5.00% 7.20% $3,564.04
    March 5.00% 7.20% $3,564.04
    April 5.00% 7.20% $3,564.04
    May 5.00% 7.20% $3,564.04
    June 4.75% 6.95% $3,486.66
    July 4.75% 6.95% $3,486.66
    August 4.75% 6.95% $3,486.66
    September 4.50% 6.70% $3,409.97
    October 4.50% 6.70% $3,409.97
    November 4.50% 6.70% $3,409.97
    December 4.00% 6.20% $3,258.71

    Why Choose an Adjustable Mortgage Rate?

    There are several benefits to choosing an adjustable mortgage, including the potential to realize immediate savings if interest rates fall and lower penalties for breaking the mortgage than fixed mortgages. There are also additional benefits of choosing an ARM versus a VRM since your amortization stays on track regardless of changes to interest rates.

    When compared to fixed-rate mortgages, ARMs offer the benefits of much lower penalties should you need to break the mortgage or wish to switch to a fixed rate in the event interest rates are expected to rise. Variable and adjustable mortgages have a penalty of 3 months’ interest, whereas fixed mortgages typically charge the higher of either 3 months’ interest or the interest rate differential (IRD). 

    Compared to VRMs, an ARM offers the advantage of immediate adjustments to your mortgage payments when the prime rate changes. VRMs, on the other hand, won’t realize these adjustments until renewal. If interest rates rise significantly over your term, you may end up with negative amortization on your mortgage and hit your trigger rate or trigger point. When this happens, you will be required to catch up to your amortization schedule at renewal, which could mean payment shock with significantly larger payments than expected. 

    Which Variable Mortgage Rate Product is Best to Choose?

    The best variable mortgage product will depend on your individual circumstances, including your financial situation, risk tolerance, and short and long-term goals. VRMs offer stability through fixed payments, making it easier to maintain a budget for those who prefer to know exactly how much they will pay each month. ARMs offer the potential for immediate cost savings and lower mortgage payments should interest rates decrease. 

    Benefits of VRMs for Borrowers

    • Adjustable Interest Rates: VRMs have interest rates that can fluctuate over time based on prevailing market conditions. This can be advantageous as borrowers may benefit, as they have historically, from lower interest rates, resulting in potential cost savings in the long run.
    • Greater Financial Control: A lower prepayment penalty on variable mortgages makes it less costly to extend the mortgage repayment period with a refinance back to the original amortization, and the potential to benefit from lower interest rates gives borrowers greater financial control. This ability allows borrowers to adjust their mortgage payments to better align with their current financial situation and make strategic decisions to optimize their overall financial goals.
    • Reduction in Taxable Income: If the VRM is on an investment property, a borrower can increase the balance (mortgage amount) and the time (amortization) they take to pay down their mortgage, potentially reducing their taxable rental income.

    These advantages make VRMs a suitable option for incorporated individuals or investors who value flexibility and control in managing their mortgage payments. However, these benefits also come with an increased risk of default or the possibility of increasing taxable income. It is recommended that borrowers consult with a financial planner before choosing a variable mortgage for these benefits.

    Benefits of ARMs for Borrowers

    • Adjustable Interest Rates: ARMs have floating interest rates, changing with the lender’s prime rate occasionally based on market conditions. Historically, it has benefitted borrowers as they could take advantage of lower interest rates to save on interest-carrying costs.
    • Greater Financial Control: Lower prepayment penalties on ARMs make it less expensive to refinance and extend your mortgage repayment term, while lowering your payment gives you more control over your finances. With a refinance, you can adjust your mortgage payments to better match your current financial situation and make smarter decisions to meet your overall financial objectives.
    • Increased Cash Flow: ARMs realize interest rate reductions on their mortgage payment whenever rates decrease, potentially freeing up cash for other household or savings priorities.

    ARMs can be a beneficial option for individuals and households with well-planned budgets who have a shorter time horizon for paying off their mortgage and do not want to increase their mortgage amortization if interest rates rise. With an ARM, initial interest rates are historically lower than a fixed-rate mortgage, resulting in lower monthly payments. 

    A lower payment at the onset of your amortization can be advantageous for those on a tight budget or who want to allocate more funds toward other financial goals. It is recommended for borrowers to carefully consider their financial situation and assess the potential risks associated with an ARM, such as the possibility of higher payments if interest rates rise during their mortgage term.

    Frequently Asked Questions about ARMs

    How does an ARM differ from a fixed-rate mortgage in Canada?

    An ARM has an interest rate that fluctuates and changes based on the prime rate throughout the mortgage term. This can result in varying monthly mortgage payments if interest rates increase or decrease during the term. Fixed-rate mortgages have an interest rate that remains the same throughout the mortgage term, which results in mortgage payments that remain the same throughout the term.

    How is the interest rate determined for an ARM in Canada?

    Interest rates for ARMs are determined based on the BoC policy rate, which directly influences lender’s prime rates. Most lenders will set their prime rate based on the policy rate +2.20%. They will then use the prime rate to set their discounted rate, typically a combination of their prime rate plus or minus additional percentage points. The discounted mortgage rate is the rate they offer to their clients.

    How can I predict my future payments with an ARM in Canada?

    Predicting future payments with an ARM is challenging due to the uncertainty around the future of BoC policy rate decisions. However, keeping updated on industry news and expert predictions can help you estimate potential future payments based on economist’s forecasts. Once the discount on your adjustable mortgage rate is set, you can use the BoC policy rate predictions to estimate changes in your mortgage payment using nesto’s mortgage payment calculator.

    Can I switch from an ARM to a fixed-rate mortgage in Canada?

    Yes, you can switch from an ARM to a fixed-rate mortgage anytime during your term. However, you will pay a penalty of 3 months’ interest if you switch to a new lender before the term ends. You also have the option to convert your ARM mortgage to a fixed-rate mortgage without switching lenders; although this option may not have a penalty, it could come with a higher fixed rate at the time of conversion.

    What happens if I want to sell my property or pay off my ARM early?

    If you sell your property or wish to pay off your ARM early, you will be subject to a prepayment penalty of 3 months’ interest, similar to a VRM.

    Final Thoughts

    Choosing an adjustable-rate mortgage (ARM) over other mortgage products will depend on your financial ability and risk tolerance. An ARM may be suitable if you are financially stable and have the risk appetite for potentially fluctuating payments during your term. An ARM can offer lower interest rates and lower monthly payments compared to a fixed-rate mortgage, making it an attractive option. 

    The key to determining if an ARM is suitable for your next mortgage lies in thoroughly assessing your financial situation, consulting with a mortgage expert, and aligning your mortgage selection with your short and long-term financial goals.

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