Definition of Variable Mortgage
A variable mortgage goes by many names. Also known as a renegotiable rate mortgage, a variable-rate mortgage, an adjustable-rate mortgage and even a floating mortgage, it is a mortgage loan whose interest rate is periodically lowered or raised based on the interest rate of the lender, which is in turn based on an indexed rate of a local central bank. Because interest rates change over time, payments on a variable mortgage may go up or down, depending on the central bank's interest index.
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Dependent on Location
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The ways in which a variable mortgage can vary will strongly depend on the index rates of the local central bank. In the United Kingdom, for example, the central bank is the Bank of England, so a mortgage's interest rates will be closely tied to its rates. In the United States, index rates can be contingent on six different indices: the London Interbank Offered Rate; the 11th District Cost of Funds Index; the Bank Bill Swap Rate; the National Average Contract Mortgage Rate; the 12-month Treasury Average Index; and the Constant Maturity Treasury. Most of Western Europe relies on the Euro Interbank Offered Rate for its index. The movement of each interest index is different, and affects borrowers in each locale in slightly different ways.
How Interest Rates are Determined for a Mortgage
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The interest rates of a bank are tied to an index that is contingent on how high or low the rate of return was on various public investments and securities, such as U.S. savings bonds and Treasury securities. The rate of return on investments depends heavily on the behavior of the financial market. The indices of central bank interest rates adjust as reflections of local financial conditions. These adjustments tend to be published annually, which is how often the interest rate on a variable-rate mortgage may vary.
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Benefits and Advantages
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The benefits of a variable-rate mortgage are readily apparent. As compared to fixed-rate mortgages, where the interest rate is guaranteed to stay the same throughout the life of the mortgage, adjustable rate mortgages tend to start out at a lower rate. This means that, at least initially, a borrower's payments may be lower than for a fixed-rate mortgage. If interest rates are expected to drop, so will the borrower's payments. And even if they are expected to rise, a borrower may be able to refinance or sell the property before the raise in the interest rate index affects his financial status.
Significant Risks
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Because the interest rate is dependent on market behavior, if interest rates increase sharply, so may the financial burden of the mortgage on the borrower. Dramatic increases in interest rates can mean dramatic increases in a borrower's payment, known as "payment shock." This is easily the biggest risk of a variable-rate mortgage: The rate increase can be such that the borrower may no longer be able to make payments on the mortgage loan.
Considerations
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If the borrower has a secure economic or job status that can handle dramatic rises and falls in a mortgage payment, the risk of interest rate changes may be worthwhile in the long run in comparison to the upfront initial savings of such a loan. If the borrower knows she may be able to quickly refinance or sell the property in light of a future sharp rise in interest rates, the risk factor may be nonexistent. Ultimately, whether a variable mortgage is right for a borrower depends on many individual considerations that are best discussed on a case-by-case basis with a financial adviser.
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