What is a variable-rate mortgage?
A variable-rate mortgage is a home loan with a variable interest rate, meaning that it changes periodically based on the movement of a financial index. It is often called an adjustable-rate mortgage, or ARM.
Interest is the amount of money a bank charges a borrower for cost of lending funds. With a variable-rate mortgage, that amount can change over the life of the loan.
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. Banks take one of those rates, which is specified in the loan agreement, and add a few percentage points – a margin – on top to calculate the amount they’ll charge customers.
The advantage of a variable-rate mortgage is that the interest rate can adjust downwards on some loans. Accordingly, these rates can adjust upward as well, making the monthly payment higher. However, some variable-rate mortgages come with caps that limit their interest rate.
Variable-rate mortgages are different from fixed-rate mortgages, the interest rate of which does not change. 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. A change in the index rate does not always trigger an equivalent change in the mortgage’s interest rate.
Looking for a good variable-rate mortgage? Bankrate can help you choose.
Variable-rate mortgage example
The most popular variable-rate mortgage is the 5/1 ARM. The borrower is given a fixed interest rate for the first five years of the loan. After that, the interest rate can change every year. Some lenders offer 3/1 ARMs, 7/1 ARMs and 10/1 ARMs as well.