A variable rate mortgage (VRM), also known as an adjustable-rate mortgage (ARM), is a type of home loan where the interest rate applied on the outstanding balance varies over time. The initial interest rate is typically lower compared to that of a fixed-rate mortgage, but it can fluctuate based on changes in the market interest rates.
How Does a Variable Rate Mortgage Work?
A VRM begins with an initial interest rate that is fixed for a certain period, known as the introductory period. After this period expires, the rate adjusts at predetermined intervals—usually annually—based on a specific financial index or benchmark, plus a margin.
Components and Terms
Initial Interest Rate
The initial rate is what you pay during the introductory period, which can last anywhere from a few months to several years, depending on the loan terms.
Adjustment Period
This is the interval at which the mortgage interest rate is recalculated. Common adjustment schedules include one year (1/1), three years (3/1), five years (5/1), and seven years (7/1).
Index and Margin
The index is a reference interest rate, such as the London Interbank Offered Rate (LIBOR), the Constant Maturity Treasury (CMT) rate, or the Secured Overnight Financing Rate (SOFR). The margin is a fixed percentage that is added to the index to determine the adjusted interest rate.
Benefits of Variable Rate Mortgages
Lower Initial Rates
One of the most attractive features of a VRM is the lower initial interest rates compared to fixed-rate mortgages. This can result in lower initial monthly payments.
Potential for Lower Costs
If market interest rates remain stable or decline, the cost of borrowing can be lower with a variable rate mortgage over the life of the loan.
Flexibility
A VRM can provide greater flexibility for borrowers who plan to sell or refinance their homes before the end of the initial interest rate period.
Downsides of Variable Rate Mortgages
Rate Increases
One significant risk is the potential for rate increases. Monthly payments could rise substantially if market interest rates climb.
Complexity
The structure and terms associated with VRMs can be complex, making it challenging for some borrowers to fully understand the potential risks and benefits.
Budgeting Uncertainty
Variable repayments can pose difficulties for budgeting and financial planning. An unexpected rate hike can strain household finances.
Special Considerations
Caps
Many VRMs come with caps that limit how much the interest rate can increase during each adjustment period and over the life of the loan.
Negative Amortization
In some cases, if a VRM has a payment cap and the interest rate increases significantly, you may not pay all the interest due each month. The unpaid interest is then added to the loan balance, creating negative amortization.
Examples
Case Study: Market with Rising Rates
Consider a borrower who took a 5/1 ARM with an initial rate of 3%. After five years, if the rates increase by 2 percentage points to 5%, the borrower’s monthly payments would increase accordingly.
Case Study: Stable Market
A borrower with a similar mortgage might experience minimal changes in their monthly payments if the market rates remain stable or decline.
Historical Context
Variable rate mortgages gained popularity in the 1980s when interest rates were highly volatile. They provided an attractive alternative to fixed-rate mortgages, which had become very expensive.
Applicable Environments
VRMs are particularly useful in certain scenarios:
- Borrowers planning to stay in their homes for a short period.
- Markets with declining interest rates.
Comparisons
Variable vs. Fixed-Rate Mortgages
- Variable-Rate Mortgages: Lower initial rates, potential for fluctuating payments.
- Fixed-Rate Mortgages: Consistent interest rate, stable monthly payments.
Related Terms
- Fixed-Rate Mortgage (FRM): A loan with a constant interest rate throughout the term.
- Interest-Only Mortgage: A type of loan where only the interest is paid for initial periods.
- Hybrid ARM: A mortgage with a fixed rate for an initial period followed by adjustable rates.
FAQs
What happens if market interest rates drop?
Are there penalties for refinancing a VRM?
How do interest rate caps protect borrowers?
References
- Federal Reserve. (2023). Understanding Adjustable-Rate Mortgages. Retrieved from [Federal Reserve Website]
- Investopedia. (2023). Variable Rate Mortgage. Retrieved from [Investopedia Website]
Summary
A variable rate mortgage offers a flexibly structured loan that begins with a lower interest rate but carries the risk of rate increases and payment variability. It benefits those planning short-term homeownership or in a declining interest rate environment but requires careful consideration of potential increases in future payments. Understanding its terms, benefits, and risks is crucial for making an informed decision.
