Variable Rate Mortgage Explained

What is a Variable Rate Mortgage?

A variable rate mortgage, often called an adjustable-rate mortgage (ARM) or a floating rate mortgage, is a type of home loan where the interest rate is tied to an index and can change periodically. This means your monthly payments are not fixed and can go up or down over the loan’s term.

Key Concepts

• Interest Rate Fluctuations: The rate adjusts based on a benchmark index (like the prime rate or LIBOR) plus a margin set by the lender.
• Payment Changes: As the interest rate changes, your principal and interest payment will also change.
• Initial Fixed Period: Many variable rate mortgages have an initial period where the interest rate is fixed, often lower than prevailing fixed rates.

Deep Dive into How it Works

The interest rate on a variable rate mortgage is typically composed of two parts: an index and a margin. The index is a publicly available benchmark rate that fluctuates with market conditions. The margin is a fixed percentage added to the index by the lender to determine your actual interest rate. For example, if the index is 3% and the margin is 2%, your rate is 5%. If the index rises to 4%, your rate becomes 6%. Lenders often impose rate caps to limit how much the interest rate can increase per adjustment period and over the life of the loan.

Applications and When to Consider One

Variable rate mortgages can be attractive for borrowers who:

• Plan to sell or refinance before the initial fixed-rate period ends.
• Expect interest rates to fall in the future.
• Can comfortably afford potentially higher payments.
• Are looking for a lower initial monthly payment.

Challenges and Misconceptions

A common misconception is that variable rates are always riskier. While they do carry the risk of rising payments, they also offer the potential for lower payments if rates fall. Borrowers must understand the adjustment periods and rate caps to manage risk effectively.

FAQs

Q: How often does the rate adjust?
A: Adjustment frequency varies but is often annually after the initial fixed period.

Q: What happens if rates increase significantly?
A: Your monthly payment will increase, potentially up to the lifetime rate cap.