A variable rate mortgage is a type of home loan in which the interest rate is not fixed. Instead, interest payments are adjusted above a specific benchmark or reference rate, such as the Prime Rate + 2 points. Lenders offer borrowers variable rate interest over the life of a mortgage loan. They can also offer a hybrid adjustable-rate mortgage (ARM), which includes both an initial fixed period followed by a variable rate that resets periodically.
Common varieties of hybrid ARMs include the 5/1 ARM, featuring a 5-year fixed term followed by a variable rate for the remainder of the loan (typically 25 more years).
Key Insights
- A variable rate mortgage employs a floating rate over part or all of the loan’s term, rather than having a fixed interest rate throughout.
- The variable rate often utilizes an index rate, such as the Prime Rate or the Federal Funds Rate, with a loan margin added on top.
- The most common instance is an adjustable rate mortgage (ARM), which typically has an initial fixed-rate period of some years, followed by adjustable rates for the rest of the loan.
How a Variable Rate Mortgage Works
A variable rate mortgage differs from a fixed rate mortgage in that rates during some portion of the loan’s duration are structured as floating, not fixed. Lenders offer both variable rate and adjustable rate mortgage products, each with differing variable rate structures.
Generally, lenders offer borrowers either fully 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 a declining rate environment, borrowers can take advantage of decreasing rates without refinancing since their interest rates decrease along with market rates.
Full-term variable rate loans charge borrowers variable rate interest throughout the entire life of the loan. The borrower’s interest rate in a variable rate loan will be based on the indexed rate and any required margin. The interest rate on the loan may fluctuate at any time during its life.
Understanding Variable Rates
Variable rates are structured to include an indexed rate with a margin added. If a borrower is charged a variable rate, they are assigned a margin in the underwriting process. Most variable rate mortgages thus include a fully indexed rate based on the indexed rate plus the margin.
The indexed rate on an adjustable rate mortgage causes the fully indexed rate to fluctuate for borrowers. In variable rate products, such as ARMs, the lender chooses a specific benchmark to index the base interest rate. Indexes can include the lender’s prime rate and various types of U.S. Treasuries. Changes in the indexed rate will alter the borrower’s fully indexed interest rate.
The ARM margin is the second component involved in a borrower’s fully indexed rate on an adjustable rate mortgage. The underwriter determines the ARM margin, which is added to the indexed rate to create the fully indexed interest rate that the borrower pays. High credit quality borrowers can expect a lower ARM margin, resulting in an overall lower interest rate. Lower credit quality borrowers will have a higher ARM margin, requiring them to pay higher rates of interest on their loan.
Some borrowers may qualify to pay just the indexed rate, typically reserved for high credit quality borrowers in a variable rate loan. Indexed rates are usually benchmarked to the lender’s prime rate but can also be benchmarked to Treasury rates. A variable rate loan charges the borrower interest that fluctuates with changes in the indexed rate.
Example of Variable Rate Mortgages: Adjustable Rate Mortgage Loans (ARMs)
Adjustable rate mortgage loans (ARMs) are a common type of variable rate mortgage product offered by mortgage lenders. These loans charge a fixed interest rate in the first few years, followed by a variable interest rate.
The terms of these loans vary by product. For example, a 2/28 ARM loan has 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 pays fixed rate interest for the first five years and variable rate interest thereafter. The rate resets annually based on the fully indexed rate at the time of the reset date.
Why Are ARM Mortgages Called Hybrid Loans?
ARMs have an initial fixed-rate period followed by a variable interest rate for the remaining loan period. For instance, a 7/1 ARM has an initial seven-year fixed rate. From the 8th year onward, the rate adjusts annually according to prevailing rates.
What Happens to Variable Rate Mortgages When Interest Rates Rise?
When interest rates rise, the variable rate on the mortgage also adjusts higher, increasing monthly payments. Note that many ARMs and variable rate loans have an interest rate cap, above which the rate cannot increase further.
What Are Some Pros and Cons of Variable Rate Mortgages?
Pros of variable rate mortgages include lower initial payments compared to a fixed-rate loan and potentially lower payments if interest rates drop. However, the downside is that mortgage payments can increase if interest rates rise, potentially leading to unaffordable payments for homeowners amid rate hikes.
Related Terms: fixed rate mortgage, indexed rate, prime rate, Treasury rates, loan margin.
References
- Consumer Financial Protection Bureau. “For An Adjustable-rate Mortgage (ARM), What Are the Index and Margin, and How Do They Work?”
- Consumer Financial Protection Bureau. “What Is the Difference Between a Fixed-rate and Adjustable-rate Mortgage (ARM) Loan?”
- Consumer Financial Protection Bureau. Y“ou Might Have Heard That LIBOR Is Going Away. Here’s What You Need to Know About LIBOR and Adjustable-rate Loans”.
