Mortgage Basics: Variable-Rate Mortgages
By Lisa Smith
A variable-rate mortgage, also commonly referred to as an adjustable-rate mortgage or a floating-rate mortgage, is a loan in which the rate of interest is subject to change. When such a change occurs, the monthly payment is "adjusted" to reflect the new interest rate. Over long periods of time, interest rates generally increase. An increase in interest rates will cause the monthly payment on a variable-rate mortgage to move higher.
Variable-rate mortgages have enjoyed a surge in popularity as a result of increasing home prices. With the price of housing skyrocketing, many would-be homeowners are being priced out of the market when they attempt to cover the costs of a new home with a traditional, fixed-rate mortgage. Variable-rate mortgages have lower initial interest rates than fixed-rate mortgages, resulting in lower monthly mortgage payments.
Qualifying for a variable-rate loan tends to be easier than qualifying for a fixed-rate loan because the payments are more affordable. This situation is particularly valuable when interest rates are high because lower payments enable buyers to afford more expensive homes.
Variable-rate mortgages have a set period of time during which an interest rate that is lower than the rate available on a fixed-rate mortgage remains in effect. This is commonly referred to as an introductory, or teaser, rate. This time period varies depending on the loan. After this period, the rate on the mortgage will vary based on the prevailing rates in the market.
Variable-rate mortgages are much more flexible than their fixed-rate counterparts, enabling buyers to choose terms that provide a lower initial payment for periods ranging anywhere from one month to 10 years.
Such flexibility enables buyers to account for things such as bonus payments, expected inheritances and economic environments where interest rates are falling, in which case the interest rate and monthly mortgage payment can actually decline over time. Variable-rate mortgages also provide lower monthly payments for people who do not expect to live in a home for more than a certain number of years and those who expect to be able to pay off their mortgages rapidly. (For related reading, see Mortgages: Fixed-Rate Versus Adjustable-Rate.)
One of the biggest risks for a homebuyer with a variable-rate mortgage is payment shock, which happens with interest rate increases. If interest rates increase rapidly, homebuyers may experience sudden and sizable increases in monthly mortgage payments, which they may have difficulty paying.
Another potential disadvantage of variable-rate mortgages is that they are significantly more complex than their fixed-rate counterparts. Because they are available in a variety of terms, choosing the right loan can be a challenge. Costs aren't easily compared, interest rates vary significantly by lender, shifting interest rates make it difficult to predict future payments and payment adjustments can make budgeting a challenge.
Some of these loans provide a period of time during which the borrower pays only the interest on the loan. When the loan's principal comes due, particularly if interest rates have risen, the amount required to service the monthly mortgage payment can increase by 100% or more. Also, many of these loans have complex terms, including penalties for loan prepayment and excessive fees for refinancing.
They also come with a complex vocabulary of terminology with which borrowers need to be familiar. A sampling of critical terms includes adjustment frequency, which refers to the frequency of time between interest rate adjustments; adjustment indexes, which help borrowers gauge the amount of expected interest rate change; margin, which helps borrowers understand the relationship between their loan rates and the underlying benchmarks used to set these rates; caps, which limit the amount by which the rate can rise with each adjustment; and ceiling, which refers to the maximum interest rate after all increases. (To learn more about drawbacks, read American Dream Or Mortgage Nightmare? and ARMed And Dangerous.)
When to Choose a Variable-Rate Loan
Variable-rate loans are generally the recommended option for people who anticipate declining interest rates, only plan to live in a particular home for a limited number of years, or anticipate being able to pay off their mortgages before the interest rate adjustment period is reached. Although they are often used by borrowers seeking to purchase more home than they can actually afford, this is not the financially prudent way to borrow money.
Likewise, even when a variable-rate mortgage is more cost effective than a traditional loan and the borrower can afford the property being purchased, the borrower also needs to be comfortable with the potential for the interest rate to increase and the payment to go up. If the thought of higher payment would keep you up at night, you might want to reconsider your choice of loan. While variable-rate loan are certainly more complicated than fixed-rate loans and are not the right choice for everyone, they can be a powerful tool that results in significant financial savings.