The variable rate mortgage

To simplify this, no principal payments will be made in the example -just interest. The mortgage limit will be 70% of the mortgage appraisal of the property. A real estate agent may say your property has a reasonable market value of $150,000, but the appraiser working for the mortgage lender may not agree.

If the mortgage appraiser says $140,000, then the borrowing limit will be 70% of that, or $98,000.

Conventional lenders usually go as high as 75% without resorting to mortgage insurance, which would bring the lending limit on this property to $105,000. The reason for the lower ratio will become apparent as you read on.

• The term can be as long as five years.
• The rate of interest in the mortgage will be the bank's prime lending rate, which is lower than market mortgage rates.
• The interest will be compounded monthly, and payable monthly. This simply means that if the prime rate in the mortgage is 12% a year, the borrower pays 1% a month. Just divide the contracted annual rate by 12.
• The mortgage can be paid off any time with a reasonable penalty.

The bank prime rate will be adjusted once a month in the mortgage deed. If it goes up 1 % in a monthly adjustment, a 12% loan becomes 13%. However, the payment remains the same.

How's that again? If the interest rate goes up, how can the monthly payment remain the same? Here's how it works:

Take the above figures. The borrower makes a monthly payment of 1% of the $98,000 ($980). When the rate goes to 13%, it would normally mean paying 1/12 of 13% of the $98,000 -or $1,061.66 but the payment stays at $980, leaving a shortage of $81.66.

This $81.66 is added to the mortgage debt, and now it is $98,081.66. In month two, the payment stays at $980 -and if the prime rate is still 13%, there will be another shortage. This time the payment will be short by $82.55, which is added to the debt.

Now, if the prime rate stays above the original contracted prime rate, the debt becomes larger each month. If it should get as high as 75% of the property value, then everybody takes another look at the loan, and one of two things will happen.

The property will be appraised again. If the appraisal indicates a higher figure, everybody just carries on, because the new appraisal will bring the loan ratio down to less than 75% of value.

But if the appraisal remains the same, the difference in each monthly payment -instead of being added to the loan principal - will be paid each month by the borrower, and there will be no more increase in the loan amount.

So what happens if the prime rate goes below the original contracted rate? Well, the borrower makes the same $980 monthly payment, but now will have credit in his mortgage account.

He doesn't knock this off his payment or get a cash refund. It is taken off the outstanding principal amount of the loan -which means he will get a bigger credit each month the prime rate stays below his contracted rate.

Rates go down, you win; rates go up, you lose.

And if the borrower isn't happy with the way things are going, he can convert to a fixed rate. But once this is done, then that's it -no turning back.

What's the drawback to this utopia of VRMs (variable rate mortgage)? Knowing when rates have peaked, or dropped as far as they'll go, is nearly impossible. And if rates fall after the VRM is booked, but then make a 180 degree turn, it won't be long before negative amortization takes hold and the amount outstanding is rising each month, not falling.

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