What is a variable-rate mortgage?
A variable-rate mortgage is a home loan with an interest rate that changes periodically based on the movement of a financial index. It is often called an adjustable-rate mortgage, or ARM.
Variable-rate mortgages are usually tied to one of these numbers: the rate on the one-year Treasury bill, the 11th Federal Home Loan Bank District cost of funds index rate or the London Interbank Offered Rate, or Libor.
A variable-rate mortgage gives the home loan borrower the opportunity to see his or her loan rate change over the life of the loan.
In addition, this mortgage is different from a fixed-rate loan, which does not see its interest rate change during the loan’s term. The variable-rate loan contract will outline specifications on when it could adjust, including if it can adjust to a lower rate, the limit of any increase or decrease at one time, and how frequently.
To be sure, the advantage of a variable-rate mortgage is that the interest rate can adjust downwards on some loans. This means the amount that the homebuyer pays each month may become less. However, these rates can adjust upward as well, making the monthly payment higher.
Still, the borrower is insulated from huge year-to-year increases in monthly payments because variable-rate mortgages come with caps limiting the amount by which rates and payments can change.
The most popular variable-rate mortgage is the 5/1 ARM. The borrower is given a lower introductory rate for the first five years of the loan. After that, the interest rate can change every year.
Variable-rate mortgage example
Stephen expects the real estate market to grow but thinks interest rates will fall. He wants to buy a home now but also wants to take advantage of these lower rates that might be available in the future. So, he selects a variable-rate mortgage. The rate may adjust over the lifetime of the loan. This could change his monthly payment.