When the prime rate starts to climb, like it has over the past couple of months, it will have an effect on the payments of most variable-rate mortgage holders.
Before continuing on, we must make the distinction between an actual variable rate mortgage (VRM), and an adjustable rate mortgage (ARM). With the (VRM), the payment does not actually change when prime changes. When prime goes up, more of the payment will go towards the interest portion, and when prime goes down, more of the payment goes towards principal. There is also another aspect to consider, in the case that the rate goes past a level where it effects the amortization schedule, the payment will have to be adjusted. With the (ARM), payments are adjusted with the fluctuation of a benchmark, typically prime in Canada.
Some institutions pass along the rate increase quicker than others do, so depending on your lender, your payments may climb faster than others.
Most lenders pass along rate increases as soon the prime rate changes, or on the first day of the following month. Other lenders adjust their rates for existing customers every three months for instance. The date of change is based on the borrower's interest adjustment date. In a rising rate environment, such as the one we have been experiencing lately this policy could definitely save a borrower some interest.
But how much interest would you actually save? There was a study conducted in order to quantify the potential savings with the adjustment policy in comparison to the common lender policy of raising variable rates as soon as prime rises. The study assumed a $250,000 mortgage, 5 year term, 25 year amortization, a June 1 closing date, and a 2.75% increase to prime (the simulated increase was split up into increments of 25bps, following each Bank of Canada meeting), The results showed that the adjustment policy saved roughly $540 in interest over the term, equivalent to saving about 5 basis points off of the interest rate. It must be noted however, that the study did assume that rates increased by 2.75% and then stayed stagnant for the remainder of the term.
Even though many argue that the odds are greater of rates increasing over the next 5 years, in light of the floor levels for the past year, it is still important to note that in a decreasing rate environment, this interest effect works in reverse.
The bottom line is, if you are looking at the variable product, another thing to consider is the lender's rate adjustment policy.