Variable Rate Mortgage

What is a Variable Rate Mortgage?

A variable rate mortgage (VRM), also known as an adjustable-rate mortgage (ARM), is a home loan where the interest rate can fluctuate over time based on changes in a specific benchmark or index. Unlike a fixed-rate mortgage, where the interest rate remains constant, a variable-rate mortgage starts with an initial fixed-rate period (often 3, 5, or 7 years) and then adjusts periodically based on market interest rates. The interest rate on a VRM is typically lower during the initial period, but after this, the rate can increase or decrease, impacting the borrower’s monthly payments.

How Does a Variable Rate Mortgage Work? 

A variable rate mortgage generally operates in two phases:

Initial Fixed-Rate Period:

Lower Starting Rate: During the initial phase (e.g., 5 years), the interest rate is fixed and often lower than that of a standard fixed-rate mortgage, providing the borrower with reduced monthly payments.

Adjustment Period:

• Rate Adjustment: After the initial period, the interest rate adjusts periodically (usually annually), based on a specific index such as the London Interbank Offered Rate (LIBOR) or Secured Overnight Financing Rate (SOFR). The new rate is calculated by adding a margin to the index rate.
• Rate Caps: To protect borrowers from sharp increases, many VRMs have caps that limit how much the rate can rise during each adjustment period and over the life of the loan. Common limits include annual caps and lifetime caps.

Why Consider a Variable Rate Mortgage? 

A variable-rate mortgage can be beneficial for some borrowers, especially those who plan to sell or refinance their home before the adjustable-rate period begins. Key reasons why someone might choose a VRM include:

• Lower Initial Payments: During the initial fixed-rate period, the interest rate is often lower than that of a fixed-rate mortgage, which can result in significant savings on monthly payments.
• Flexibility: If a borrower plans to move or refinance within a few years, a VRM may be ideal since the lower initial rate can lead to savings during the early years.
• Potential for Lower Rates: Depending on market conditions, the interest rate may decrease after the fixed period, reducing the borrower’s monthly payments further.

Example of a Variable Rate Mortgage in Action Suppose a borrower takes out a 5/1 ARM for $300,000. For the first five years, the interest rate is fixed at 3%. After that, the rate adjusts annually. If, after five years, the index rate rises by 1%, the borrower’s new interest rate could increase to 4%, depending on the margin added by the lender. This change would result in higher monthly payments for the remainder of the loan.

Pros and Cons of a Variable Rate Mortgage

Pros:

• Lower Initial Payments: The initial interest rate is often lower, making monthly payments more affordable during the fixed-rate period.
• Flexibility: Ideal for borrowers who plan to sell or refinance before the adjustable period begins.
• Potential Savings: If interest rates decrease after the adjustment period, the borrower may benefit from lower payments.

Cons:

• Rate Increases: After the initial period, the interest rate may rise, leading to higher monthly payments and increased overall borrowing costs.
• Uncertainty: The unpredictable nature of rate adjustments can make it harder to budget for future payments.
• Complex Terms: Borrowers need to understand the terms of the adjustment period, including caps and margins, to avoid surprises.

Conclusion A variable rate mortgage can offer lower payments during the initial years, making it an attractive option for borrowers who plan to sell or refinance their home before the adjustable rate kicks in. However, it also comes with risks, as future rate increases can significantly raise monthly payments. Understanding the adjustment terms, caps, and market trends is key to making an informed decision about a VRM.

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