A variable-rate mortgage (also called an Adjustable Rate Mortgage, ARM) is a loan in which the interest rate paid on the outstanding balance varies according to a specific benchmark. Typically, the initial interest rate is fixed for a specified period of time, and then it periodically adjusts. As the interest rate on the mortgage adjusts, the monthly payment adjusts.
The monthly payment for a variable-rate mortgage is initially lower than a fixed rate in most cases. But if interest rates go up, the monthly payment can rise above what it would have been if the borrower had chosen a fixed-rate mortgage.
Homebuyers and Realtors alike need to be mindful of the pros and cons of variable-rate mortgages, since there’s a temptation to go with a variable-rate mortgage just because it has an initial lower payment.
Pros of a Variable-Rate Mortgage
Variable-rate mortgages typically gain in popularity as home prices increase, because the initial monthly payment is lower than a fixed-rate mortgage. As a result, homeowners can purchase a more expensive home with a variable-rate mortgage.
Advantages of an adjustable-rate mortgage over a fixed-rate mortgage include:
- Variable-rate mortgages have an introductory, or teaser, interest rate at the beginning for a specified period of time, which is customarily lower than a fixed-rate mortgage. After the introductory period, the interest rate fluctuated according to the terms of the mortgage.
- Homebuyers can more easily qualify for a variable-rate mortgage, because the initial monthly payment is lower.
- Homebuyers can purchase a more expensive home, because the initial monthly payment is lower.
- Variable-rate mortgages provide more flexibility than fixed-rate mortgages.
- Homebuyers with a fluctuating income resulting from periodic bonuses and commissions can benefit from the lower monthly payments of a variable-rate mortgage, because they have the ability to make lump sum payments throughout the year.
- Homebuyers who will be in their home for a short time, and anticipate a stable or declining interest rate environment, can take advantage of low introductory rates since they will be selling in a few years.
Cons of a Variable-Rate Mortgage
Homeowners with a variable-rate mortgage share the risk of rising interest rates with the lender; therefore, these mortgages have more inherent risk. For this reason, variable-rate mortgages are not suitable for most homebuyers.
Disadvantages of a variable-rate mortgage compared to a fixed-rate mortgage include:
- Payments fluctuate after the introductory period. Homeowners must adjust their monthly household budget as their mortgage payment increases and decreases.
- Monthly mortgage payments increase if interest rates move up. Homeowners need to have the means to pay a higher mortgage payment if interest rates move upward.
- Variable-rate mortgages are more complex than fixed-rate mortgages, so the terms of the loan and the vocabulary can be confusing.
- Some of the vocabulary homeowners with a variable-rate mortgage should know include adjustment frequency, adjustment index, margin, cap, and ceiling.
Who Might Choose a Variable-Rate Mortgage?
Variable-rate mortgages are generally recommended for people who anticipate declining interest rates, plan to live in a particular home for a few years, or anticipate paying off their mortgages before the interest rate adjustment period. These homebuyers must also have the disposable income to make higher mortgage payments in the event they stay in the home longer and interest rates rise.
While a variable-rate mortgage can be a powerful financial tool resulting in significant financial savings, it’s not the best choice for most homebuyers. The majority of people purchasing a home will choose a fixed-rate mortgage because of the stability it provides over the long term.