What Is a Variable Rate Mortgage?
A variable rate mortgage is a type of home loan in which the interest rate is not fixed. Instead, interest payments will be adjusted at a level above a specific benchmark or reference rate, such as the Prime Rate + 2 points. Lenders can offer borrowers variable rate interest over the life of a mortgage loan. They can also offer a hybrid adjustable-rate mortgage (ARM), which includes both an initial fixed period followed by a variable rate that resets periodically thereafter.
Common varieties of hybrid ARM include the 5/1 ARM, having a 5-year fixed term followed by a variable rate on the remainder of the loan (typically 25 more years).
- A variable rate mortgage employs a floating rate over part or all of the loan's term, rather than having a fixed interest rate throughout.
- The variable rate will most often utilize an index rate, such as the Prime Rate or the Fed funds rate, and then add a loan margin on top of it.
- The most common instance is an adjustable rate mortgage, or ARM, which will typically have an initial fixed-rate period of some years, followed by regular adjustable rates for the rest of the loan.
How a Variable Rate Mortgage Works
A variable rate mortgage differs from a fixed rate mortgage in that rates during some portion of the loan’s duration are structured as floating, and not fixed. Lenders offer both variable rate and adjustable rate mortgage loan products with differing variable rate structures.
Generally, lenders can offer borrowers either fully amortizing or non-amortizing loans that incorporate different variable rate interest structures. Variable rate loans are typically favored by borrowers who believe rates will fall over time. In falling rate environments, borrowers can take advantage of decreasing rates without refinancing since their interest rates decrease with the market rate.
Full-term variable rate loans will charge borrowers variable rate interest throughout the entire life of the loan. In a variable rate loan, the borrower’s interest rate will be based on the indexed rate and any margin that is required. The interest rate on the loan may fluctuate at any time during the life of the loan.
Variable rates are structured to include an indexed rate to which a variable rate margin is added. If a borrower is charged a variable rate, they will be assigned a margin in the underwriting process. Most variable rate mortgages will thus include a fully indexed rate that is based on the indexed rate plus margin.
The indexed rate on an adjustable rate mortgage is what causes the fully indexed rate to fluctuate for the borrower. In variable rate products, such as an ARM, the lender chooses a specific benchmark to which to index the base interest rate. Indexes can include the lender’s prime rate, and various different types of U.S. Treasuries. A variable rate product’s indexed rate will be disclosed in the credit agreement. Any changes to the indexed rate will cause a change for the borrower’s fully indexed interest rate.
The ARM margin is the second component involved in a borrower’s fully indexed rate on an adjustable rate mortgage. In an ARM the underwriter determines an ARM margin level which is added to the indexed rate to create the fully indexed interest rate that the borrower is expected to pay. High credit quality borrowers can expect to have a lower ARM margin which results in a lower interest rate overall on the loan. Lower credit quality borrowers will have a higher ARM margin which requires them to pay higher rates of interest on their loan.
Some borrowers may qualify to pay just the indexed rate, which can be charged to high credit quality borrowers in a variable rate loan. The indexed rates are usually benchmarked to the lender’s prime rate; however, it can also be benchmarked to Treasury rates. A variable rate loan will charge the borrower interest that fluctuates with changes in the indexed rate.
Example of Variable Rate Mortgages: Adjustable Rate Mortgage Loans (ARMs)
Adjustable rate mortgage loans (ARMs) are a common type of variable rate mortgage loan product offered by mortgage lenders. These loans charge a borrower a fixed interest rate in the first few years of the loan followed by a variable interest rate after that.
The terms of the loan will vary by particular product offering. For example, in a 2/28 ARM loan, a borrower would pay two years of fixed rate interest followed by 28 years of variable interest that can change at any time.
In a 5/1 ARM loan, the borrower would pay fixed rate interest for the first five years with variable rate interest after that, while in a 5/1 variable rate loan, the borrower’s variable rate interest would reset every year based on the fully indexed rate at the time of the reset date.
Why Are ARM Mortgages Called Hybrid Loans?
ARMs have an initial fixed-rate period followed by the remainder of the loan using a variable interest rate. For instance, in a 7/1 ARM, the first seven years would be fixed. Then from the 8th year onwards, the rate would adjust on an annual basis depending on prevailing rates.
What Happens to Variable Rate Mortgages When Interest Rates Go Up?
When interest rates go up, the variable rate on the mortgage will also adjust higher. This means that the monthly payments on the loan will also increase. Note than many ARMs and other variable rate loans will have an interest rate cap, above which the rate can not increase any further.
What Are Some Pros and Cons of Variable Rate Mortgages?
Pros of variable rate mortgages can include lower initial payments than a fixed-rate loan, and lower payments if interest rates drop. The downsides are that the mortgage payments can increase if interest rates rise. This could lead to homeowners being trapped in an increasingly unaffordable home as interest rate hikes occur.