The Partially Amortized, Blended Constant Payment Mortgage – Variable Rate
The main feature of this type of mortgage is that a variable rate mortgage has an interest rate that fluctuates.
This type of repayment plan is designed to protect the Lender from mismatching funds that it has on deposit. As their rates paid on deposit, such as bank accounts and investments fluctuate, so does the rate of the variable rate mortgage. This allows a Lender to keep the spread between what it is paying on its deposits to what they are receiving on their mortgages more consistent, thus protecting profit margins.
For this increased security to the Lender, the borrower tends to receive a lower rate than on a fixed rate mortgage.
At the beginning of the mortgage, the payment is typically set at the Lender’s posted 3 year rate.
Many Lenders offer a capped variable rate mortgage that caps the amount of the interest that can be charged at that present rate, which is typically included in a Schedule attached to the Standard Charge Terms.
The rate fluctuation is normally tied to the Lender’s current prime rate and can be reset monthly. Typically variable rate mortgages carry interest rates that are lower than their fixed rate mortgages. For example, a Lender may offer its variable rate mortgage at its prime rate minus 50 basis points (a basis point is 1/100th of 1 percent, therefore there are 100 basis points in 1 percent). If its current rate is 3.00%, then its current variable rate would be 3.00% – .5% = 2.50%.
In this type of variable rate mortgage, the payment remains the same, or constant, while the percentage of the payment allocated to interest and principal fluctuates according to the current interest rate. If the rate goes up, more of the payment is comprised of interest, and vice versa. If the rate was to rise past a certain point, the borrower would not be repaying all of the interest for the period, let alone any principal. This would result in a negative amortization; in other words the mortgage would not be paid off during the amortization period. In fact, it would extend beyond the contracted amortization period. For this reason Lenders will have a clause in the Standard Charge Terms that indicates that if the amount of the loan exceeds a set percentage the Lender has the right to increase the payment amount.
Benefits:
Savings – For borrowers who are not “risk sensitive’ (fluctuations in rates do not cause them stress) this type of repayment plan can save them money. In most cases, the rate for variable rate mortgage has been lower than those of fixed rate mortgages.
Ability to switch to a Fixed Rate – Most variable rate mortgages offer the flexibility of allowing the borrower to switch to a fixed rate product through the same Lender without penalty. This provides the borrower with the comfort of being able to switch if the variable rate begins to rise.
Risks:
Volatility – This type of mortgage, while being able to save the borrower money, can also have the reverse affect if the Lender increases its rates. The borrower must be financially sophisticated enough to keep a close watch on rates and make the decision to switch to a fixed rate product if and when the situation warrants it.
Negative Amortization – If the interest rate rises, the possibility exists that the fixed payment will not be sufficient to cover the interest due for the repayment period. This will cause the borrower to potentially enter a negative amortization scenario, which can force him or her into increasing his or her mortgage payment or paying a lump sum of money to the Lender to return the mortgage to a positive amortization.
Payment Increase – As mentioned under Negative Amortization, if the borrower falls into that category and must increase his or her payment, the question then becomes can the borrower afford the higher payment?
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