August 2000

Variable Mortgages
Worth a Look

© Talbot Stevens

Some lenders are heavily promoting mortgages with rates “below prime”.

One is promising 1.01% below prime. Sounds great, but the fine print reveals several important facts. First is that the 1.01% discount is a temporary teaser rate that only applies for the first 9 months. Then the rate is prime minus 0.25% for the rest of a 5-year term. Another lender offers 2.25% below prime, but just for the first 3 months. Then you pay prime minus 0.375% for the rest of a 6-year term.

Unlike conventional mortgages where the rate is fixed for the length of the term, the interest rate on below-prime mortgages fluctuates as prime changes. This means that payments will increase if rates rise. If you can handle the worst case of higher payments, variable mortgages are worth a look, especially if you expect rates to level out or drop.

Aside from the below-prime interest rates, variable mortgages have other attractive features. Most become fully convertible or open after 3 years. This means that while you might sign up for a 5-year term or longer, you are only locked in for 3.

On the downside, borrowers need to check how the interest rate is calculated. Conventional mortgages compound interest semi-annually. Although most consumers don't realize it, an 8% loan compounded semi-annually really costs 8.16% per year. If an 8% loan is compounded monthly, the real annual interest cost is 8.3%.

Since many variable mortgages are compounded monthly, like with most car and consumer loans, the real cost could be higher than you think.

So how does the cost of a variable rate product stack up against a conventional 5-year closed mortgage? It depends mostly on what interest rates do in the future. Although some feel that rates might not rise much further, no one really knows what the price of anything will be in the future.

Right now, posted rates for 5-year terms are 8.45%. With prime at 7.5%, the variable mortgage charges 7.25% or less. This is at least 1.2% below the 5-year closed rate.

Thus, it is easy to see that if rates in the next 5 years average what they are now or drop, the variable rate offering is cheaper, even for those who can negotiate 1% off. The extra teaser discount at the start, and the convertibility after 3 years are bonuses.

For non-negotiators, rates would have to rise 1.2% before you started paying as much as someone that locked in with the closed mortgage.

Normally, mortgages with shorter terms charge about 1% less than longer 5-year terms. This leads to the strategy of sticking with cheaper, shorter terms if you can handle potentially higher payments when you renew.

One benefit of a 6-month convertible mortgage, or a variable one after 3 years, is that if rates do drop, you can instantly convert to a new, cheaper one with a simple phone call.

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