What Is a Variable Rate Mortgage?

Not all home loans are created equally. Among the several mortgage loan programs on the market, the variable rate mortgage is perhaps one of the most popular and one of the most misunderstood. Variable rate mortgages work much differently than fixed loans.

Identification

A variable rate mortgage is a home loan where the interest rate and monthly payments vary during its term. Variable rate mortgages are attached to the base lending rates of central banks or stock and bond indexes. When a bank's base rate or an index changes, variable rate mortgage rates of interest, therefore, follow suit. In the United States, variable rate mortgages are known as adjustable rate mortgages, or "ARM" loans.

Types

Some of these indexes that determine adjusted rates on ARMs are: Cost of Funds Index (COFI), London Interbank Offered Rate, (LIBOR) index and the Monthly Treasury Average Index (MTA). Depending on how a particular lender markets its variable rate home loans, mortgage interest rates will either fluctuate directly with the movement of an index, or by predetermined percentage points decided upon by the bank. Because lenders cannot predict how the indexes will perform in the future, many starting rates and predicted adjustments are set before financing is made. For example, a LIBOR ARM may contain an adjusted interest rate that is equal to the current index plus 3 percent. Most ARM loans do contain limits to how much their rates may increase. These limits are called "caps." This means that a loan with a start rate of 3 percent, may have a 10 percent cap. For loans with caps, rates may adjust anywhere form the start rate to the cap during adjustment periods, but never exceed it.

Benefits

Despite the fact that variable rate mortgages change according to specific indexes, they do offer strong benefits to homeowners. The most significant benefits are the often extremely low initial interest rates. Some ARMs have initial rates as low as 2 to 3 percent. This means that for an initial period of time, a homeowner will enjoy very low mortgage payments. Obtaining this type of financing is, therefore, beneficial for an individual that may only need financing for a short time. Most ARM customers either sell their homes or refinance before or shortly after the adjustments begin. It is also common for homeowners to opt for a low ARM rate if fixed rates are higher than desired at the the time financing is sought. It is common for variable rate mortgages to remain fixed for initial periods of one, three, five and seven years.

Warning

Variable rate mortgages were quite popular in the late 1990s and into the new millennium. A significant percentage of homeowners did utilize the programs correctly and either sold their homes before their loans adjusted or were able to refinance into fixed mortgages. However, a large percentage of people found themselves unable to sell their homes or obtain fixed financing. These homeowners, in turn, were suddenly unable to make their mortgage payments, which led to a sea of home foreclosures. It is, therefore, crucial for homeowners to understand that although there are almost always rate caps on ARMs, the differences between payments calculated at an adjusted rate and the payment amounts during fixed periods are often staggering. Many variable rate mortgages also contain negative amortization. This means that monthly payments are often not large enough to cover the interest that accrues during current payment periods. The shortfall is, therefore, added to the loan amount, eating up equity and making the entire mortgage obligation that much greater. If you are considering obtaining a variable rate mortgage, it is important to consider your future options as well as your immediate needs. Will you be able to afford your house payments if they suddenly increase? Is your housing market strong in the event you wish to sell before your rate adjusts? Will your credit allow you to refinance into an affordable fixed loan after your existing ARM begins to vary? Having solid answers in your favor to these questions is important in choosing a home loan that fits your needs.

Considerations

Variable rate mortgages are specialized loan products that serve specific purposes. They are not meant to be used as long-term financing options. It is, therefore, wise to choose a fixed loan if there is anything about a homeowner's situation that may cause them, at any time, to be stuck paying mortgage payments that do not fit into their budgets. Avoiding often horrific consequences may involve giving a sizable down payment when purchasing to reduce amounts financed, or the avoidance of buying more house than you need in terms of sales price.