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 LIBOR + 2 points). Lenders can offer borrowers variable rate interest over the life of a mortgage loan. They can also offer an adjustable rate mortgage which includes both a fixed and variable rate that resets periodically.
The Basics of a Variable Rate Mortgage
A variable rate mortgage differs from a fixed rate mortgage in that rates during some portion of the loan’s duration are structured as variable. Lenders offer both variable rate and adjustable rate mortgage loan products with differing variable rate structures.
Generally, lenders can offer borrowers either 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.
Variable Rate Interest
Variable rates are structured to include an indexed rate and variable rate margin. If a borrower is charged a variable rate, they will be assigned a margin in the underwriting process. Most variable rate mortgages will pay a fully indexed rate that is based on the indexed rate plus margin.
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 LIBOR. Treasury rates. A variable rate loan will charge the borrower interest that fluctuates with changes in the indexed rate.
Full-Term Variable Rate Loans
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.
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.
Terms of the loan will vary by 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.