There are an overwhelming number of mortgage options available on the market, the variable-rate mortgage is just one of the options. In this article, we’ll explore precisely what a variable-rate mortgage is, how they differ from traditional fixed-rate mortgages, and what the benefits and risks are of taking one out against your property.
What Is a Variable-Rate Mortgage?
Variable-rate mortgages differ from other types because the rate of interest that is accrued changes on a regular basis. The rate that is charged varies from month to month and is usually on a point system on top of the Prime Rate. For example, a variable-rate mortgage could be Prime Rate + 3 points.
A slight variation would be the adjustable-rate mortgage (ARM). The ARM products start their life as fixed-rate mortgages and then turn into variable-rate mortgages after that.
Variable-rate mortgages, in general, can be either run on a capital repayment or interest-only basis. As with all mortgages, interest-only mortgages will have lower monthly payments but you will never be reducing the overall capital repayment.
Variable-Rate Mortgage vs Fixed-Rate Mortgage
Variable-rate mortgages are generally attractive to people who have an eye on market conditions. If you believe that interest rates are going to reduce over the term of the mortgage then you can benefit from reduced payments in line with the Prime Rate’s fluctuation. The converse, however, is also true. Should rates increase, your payments will increase.
There is an element of gambling with variable-rate mortgages, gains are there to be made, but also some people can lose out if interest rates hike. Fixed-rate mortgages, on the other hand, are a far safer bet. In fact, there’s no betting at all.
A fixed-rate mortgage is precisely that, a rate that is fixed for the whole initial term of the mortgage. Purchasers choose a rate that is set for the chosen duration, this is often just above current market rates. They’re a great choice if you believe that interest rates are low and are unlikely to get lower, or that you believe interest rates are due to increase within the next x years. Yes, there’s a chance that rates might get lower after you sign for your term, and then you’ll be paying above market rate, but you’ll know that your payments will be exactly the same for the duration of the initial term. They’re typically seen as the safest option and account for [90% of all mortgages](https://www.mpamag.com/us/mortgage-industry/guides/the-7-most-popular-types-of-mortgage-loans-for-home-buyers/255499#:~:text=Fixed-rate mortgage or conventional,mortgage type in the country.).
Structure of a Variable-Rate Mortgage
When selecting a variable-rate mortgage there are two key parts, the index rate, and the variable rate margin. The index rate is chosen by the lender and typically matches or refers to the lender’s Prime Rate or rates set by the U.S. Treasuries. The variable rate and the index rate will be laid out clearly before any product can be purchased. Details are included in credit agreements and will be clearly advertised before signing.
The majority of lenders will offer lower variable rates to borrowers that they deem less risky. That includes borrowers asking for smaller loans or borrowers that can stake a larger initial deposit.
Example of a Variable-Rate Mortgage
Let’s say that you see a variable-rate mortgage that is advertised as 3.6% (3.5% plus 0.1%). This means that you’ll always be charged 3.5% interest plus the current variable rate which would be 0.1%. If, however, rates increase to 0.25%, your payable interest will be 3.75%. This would be a significant increase in payments for any borrower.
Using the above rates as an example we can see how much the monthly payments would change:
- Total borrowing: $250,000 over a 30-year term
- At 3.6% monthly payments would be $1,137 a month.
- At 3.75% monthly payments would be $1,158 a month.
These were typical rates in 2021. 2021 rates seem to be a thing of the past. Now let’s say that you were on a tracker rate that is now at the average of 7.32% in 2022 in the U.S. That same repayment that was $1,137 a month at 3.6% is now at $1,697.
Variable-Rate Mortgage Pros and Cons
Variable-rate mortgages have both their pros and cons, they are certainly not as popular as fixed-rate but more and more people are considering them as an option.
Variable-Rate Mortgage Pros
- There’s a chance that your payments will decrease versus the initial payment that you make.
- The initial rates are typically lower than their fixed-rate alternatives.
Variable-Rate Mortgage Cons
- Cost forecasting and budgeting are harder as your mortgage payments (likely your biggest outgoing) will vary both up and down.
- If mortgage rates increase, your monthly payments will increase too.
- There’s an element of gambling to variable-rate mortgages, and that’s not a premise for everyone.
Key Takeaways
Variable-rate mortgages certainly have their appeal. Having the opportunity for monthly payments to decrease isn’t to be ignored, but there’s always the chance that they could increase. Paying attention to the current economic forecast can likely indicate whether variable mortgages are a good idea versus a fixed rate.
- When calculating if a variable-rate mortgage is right for you, consider the worst-case scenario and ensure that you can still keep up with the monthly repayments.
- Prime Rates vary from lender to lender, pay close attention to the rate they set rather than having one rate stuck in your mind.
