Definition
A Variable Rate Mortgage, also known as an Adjustable Rate Mortgage (ARM), is a type of home loan where the interest rate can change over time, typically based on an index plus a set margin. The interest fluctuations are often tied to changes in a specific benchmark rate. This can result in shifts in the borrower’s monthly payments throughout the loan term.
Key Takeaways
- A Variable Rate Mortgage, often referred to as an Adjustable Rate Mortgage, is a type of mortgage in which the interest rate applicable on the outstanding balance varies throughout the length of the mortgage term.
- Unlike Fixed Rate Mortgages where interest rates are fixed and predictable, Variable Rate Mortgages have interest rates that are tied to a benchmark interest index. This means the interest rate, and thus the payment, can change over time, potentially resulting in higher payments.
- Though Variable Rate Mortgages may pose risks due to fluctuating rates, they also offer benefits such as lower initial interest rates compared to fixed-rate mortgages. One has the potential to save on cost if market interest rates fall.
Importance
Variable Rate Mortgage is an important finance term because it refers to a type of mortgage where the interest rate can change during the term of the loan.
Borrowers who choose to take out a variable rate mortgage take on a certain amount of risk because the amount of their monthly mortgage payment can fluctuate, depending on changes in interest rates.
However, these types of loans can also offer lower initial interest rates than fixed-rate mortgages, making them attractive to borrowers who plan to sell or refinance their home before the rate adjusts.
Understanding this concept is crucial for any potential homeowner or real estate investor when planning their budget and managing long-term financial commitments.
Explanation
A Variable Rate Mortgage, also known as an Adjustable Rate Mortgage (ARM), serves as a viable financial tool for prospective borrowers who desire flexibility. Its primary purpose is to offer a lower initial interest rate compared to Fixed Rate Mortgages, making it an ideal choice for those who intend to sell or refinance their home before the rate adjustments occur. It allows potential homebuyers to afford more expensive homes due to lower initial mortgage payments.
Variable Rate Mortgages are especially advantageous in a falling interest rate scenario because as rates fall, the borrower’s future payments can decrease. Besides, Variable Rate Mortgages are commonly utilized by lenders as a risk management tool against interest rate volatility. The fluctuation in interest rates is transferred from the lender to the borrower in this setup.
Therefore, in an economic scenario where the interest rates rise, mortgage lenders are not locked into low return rates, making Variable Rate Mortgages a hedging tool against interest rate risk. It’s imperative for borrowers to understand, however, that while such mortgages offer initial savings, the total expense over the loan’s lifetime could indeed become more expensive if interest rates rise. Thus, the use of a Variable Rate Mortgage involves a degree of conjecture about future economic conditions and interest-rate trends.
Examples of Variable Rate Mortgage
John’s House Purchase: In 2010, John decided to purchase a house for the first time. He opted for a variable rate mortgage since the interest rates were low at that time. John’s interest rate fluctuated with the market rates; while he paid less in interest when rates were low, when the rates went up, so did his monthly mortgage payments.
Sarah’s Investment Property: Sarah decided to buy an investment property in a growing neighborhood. She chose a variable rate mortgage, anticipating that she would rent out the property and adjust the rent according to interest rate fluctuations. This strategy allowed her to manage the higher mortgage payments during periods of high interest rates.
David’s Refinance Plan: David, who originally took a fixed rate mortgage for his home, decided to refinance to a variable rate mortgage in
He chose this option since the interest rates were dropping and this would result in lower monthly payments. He planned to sell the house before the rates go up, thus minimizing the risk associated with rate increases.
FAQs about Variable Rate Mortgage
What is a Variable Rate Mortgage?
A variable rate mortgage, also known as an adjustable rate mortgage, is a type of home loan where the interest rate changes over time based on market conditions. The mortgage payments may increase or decrease depending on the change in the interest rate.
How does a Variable Rate Mortgage work?
In a variable rate mortgage, the interest rate is initially set below the rate of a fixed-rate loan. After a set period, this rate will start to adjust at preset intervals, often annually. The new rate is determined by the market rates and the terms set by the lender.
What are the pros and cons of a Variable Rate Mortgage?
Variable rate mortgages initially have lower interest rates than fixed-rate mortgages, which may make them more affordable at the start. They also offer the opportunity to save on interest if rates decrease. However, they come with a level of uncertainty, since rates may also increase, causing higher payments over time.
When should one consider a Variable Rate Mortgage?
A variable rate mortgage could be considered if you expect interest rates to drop in the future. It’s also a good option if you plan to sell your home and pay off the mortgage before the rate starts adjusting. As always, it’s important to assess your financial situation and risk tolerance before deciding.
Related Entrepreneurship Terms
- Adjustable Rate Mortgage (ARM)
- Interest Rate Caps
- Initial Interest Rate
- Rate Adjustment Period
- Principal Balance
Sources for More Information
- Investopedia: A comprehensive online resource for understanding finance and investing terminology, including variable rate mortgages.
- Bankrate: A reliable platform to learn more about different types of mortgages, all the ins-and-outs about variable rate mortgages can be found here.
- Consumer Financial Protection Bureau: A U.S. government agency that makes sure banks, lenders, and other financial companies treat consumers fairly including providing quality information on mortgage types.
- Nerdwallet: An excellent resource offering free tools and clarity for all of life’s financial decisions, including those concerning variable rate mortgages.
