What is Variable-Rate Mortgage?
A variable-rate mortgage is also known as an adjustable-rate mortgage (ARM). It refers to a type of home loan where the interest payment is not fixed but changes periodically to reflect the prevailing interest rates.
An adjustable-rate mortgage is tied to a short-term interest rate, whose shocks directly affect the variable rates, unlike a fixed mortgage rate, whose interest rate is long term and less sensitive to adjustments in the policy rate. Typically, the retirement age plays an essential role in granting maximum maturity.
- A variable-rate mortgage is a form of home loan where the interest rate is changed periodically to match the fluctuations in the benchmark interest rate.
- Most borrowers prefer a variable-rate mortgage when they anticipate a future decline in interest rates.
- A variable-rate interest is structured with a variable-rate margin and an indexed rate where a borrower is assigned the margin during the underwriting process.
Principles of a Variable-Rate Mortgage
The fundamental premise of the variable-rate mortgage rate is to alleviate the shocks of high and volatile rates of interest and inflation in the housing industry. It differs from a fixed mortgage rate, in that it is set at the discretion of the lender, rather than being tied to an external reference.
Mortgage lenders can either give amortizing or non-amortizing mortgage loans with different payment levels. The repayment options within the model come with different interest rate structures. Borrowers who anticipate a fall of interest rates favor variable-rate mortgages.
If interest rates are heading lower, borrowers are better placed to take advantage of the falling rates without necessarily refinancing, given that their interest rates change with that of the market. The prepayment option allows borrowers to prepay the loan at an arbitrary date before maturity.
Pricing Model for Amortized Variable-Rate Mortgage
The contract rate of the variable mortgage rate is adjusted periodically to match the current market rates. One assumption that stands out is the simplicity of the pricing model of the variable mortgage, in that the borrower is exempt from the penalty cost at prepayment.
Most often, the borrower is given another option referred to as the default option, which involves foregoing the contract for the benefit of the physical good of the mortgage. However, the lender stops receiving streams of revenue if the borrower resorts to such an option. Since the market rates move with the market trends, borrowers can take advantage of the falling rates without necessarily refinancing their loans.
The structure of variable interest rates incorporates a variable-rate margin and an indexed rate, and in the process of margin underwriting, a borrower will be assigned a margin if charged a variable rate. Most of the variable rates obtain interest rates by summing up a unique index rate and a margin.
However, under certain circumstances, some borrowers may only qualify to pay index rates, which can be charged to borrowers with a high credit profile. The lender’s prime rates usually serve as the standard benchmark for the indexed rates. The indexed rate can also be benchmarked to the money market mortgage, also known as the London Interbank Offered Rate (LIBOR). Thus, borrowers of variable-rate loans will be charged interest that changes as indexed rate changes.
Benchmarking implies that regardless of the current interest rate, there is a maximum limit that borrowers are to be charged. In some scenarios, borrowers are forced to purchase interest rate insurance to cap adjustment of interest rates. Alternatively, borrowers can lock in their rate by initiating a forward mortgage rate contract up to a certain period before adjustments.
Full-Term Variable Rate Loan
A full-term variable-rate loan is a type of loan that charges a variable interest rate for the entire duration of the loan. Nevertheless, in the context of a variable-rate mortgage, the indexed margin, and the required margin are used to determine the interest rate to be charged. During the entire life of the borrower, the interest rate is subject to change.
Practical Examples of Variable-Rate Mortgage
Most lenders offer mortgage loans where a fixed interest rate is charged in the first few years before changing to a variable-rate interest. Payment terms of the loan will vary according to the product offering.
For example, in a 5/1 ARM loan, the borrower is required to pay a fixed-rate interest for the first few years before the lender imposes a variable interest rate. A 2/28 ARM loan is another instance where, in the first two years, a borrower is obliged to pay a fixed interest rate. After the time’s elapsed, the lender assigns a 28-year-old interest rate that fluctuates periodically.
Other Common Types of Mortgage Rates
In addition to a variable-rate mortgage, lenders can offer other forms of interest rates on home loans. The rates come with different upsides and downsides to borrowers, some of which include discount mortgages, capped mortgages, and offset mortgages.
Lenders use discount mortgage rates to discount off the loan and are only applicable after a certain period.
Capped-rate mortgages move in line with the lenders’ standard variable rate, only that the interest rate cannot surpass a specific limit.
In an offset mortgage, lenders link the borrower’s savings and current account to the mortgage so that only the interest rate on the difference is paid.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: