What Is a Variable-Rate Mortgage?

A variable-rate mortgage has an interest rate that is not fixed for the full mortgage term. It can either have an annual rate update or an initial fixed rate before switching to a variable rate.

Homebuyers can choose among various types of loans, including fixed-rate and variable-rate mortgages. With a variable-rate mortgage, homebuyers may get lower interest rates or at least the possibility of lower interest rates in the future. Instead of a fixed interest rate, the interest rates of a variable-rate mortgage are fixed to a specific benchmark or reference rate, such as the prime rate, London Interbank offered rate (LIBOR), or various rates on U.S. Treasury bills and notes. Read on to understand variable rate mortgages and whether you should get one. 

Understanding Variable-Rate Mortgages

A variable-rate mortgage is any mortgage in which the interest rate is not fixed for the full term of the mortgage. In some cases, interest rates are updated annually, while other variable-rate mortgages have an initial fixed rate, usually for two to five years, before shifting to a variable rate. 

Variable interest rates are linked to a benchmark rate. The most common benchmarks for U.S. mortgages are the prime rate and Secured Overnight Financing Rate (SOFR). LIBOR was one of the most common benchmarks, but it faced criticism, and since January 2022, hasn’t been used to issue new home loans in the U.S. 

If your lender uses a prime benchmark, the lender will quote the rate as prime plus or minus a percentage discount or premium. For example, a variable rate could be quoted as prime minus 0.5% or prime plus 2%. If the prime rate is, 5%, and your rate is plus 1%, the rate you will pay is 6% interest.

How Does a Variable-Rate Mortgage Work?

Variable-rate mortgages work like traditional mortgages. You’ll be approved for a variable-rate mortgage based on your income, assets, credit score, and other variables. The lender will state the terms of the variable interest rate. For example, the lender may state the interest rate for the first year, which benchmark the interest rate is linked to, and the frequency of updates. 

In other cases, mortgage lenders offer a hybrid adjustable-rate mortgage (ARM). In that case, there’s an initial fixed period, after which the mortgage shifts to a variable rate that resets periodically. ARMs are growing in popularity, especially with the current high interest rates. 

There are three numbers to look for in an ARM: the initial cap, the periodic cap and the lifetime cap. These are designed to protect you from soaring interest rates.

• The initial cap is the fixed rate for an introductory period and represents the maximum the interest can increase during a set introductory period. Initial caps usually range from 2% to 5%.
• A periodic cap limits how much interest can change during all adjustment periods going forward. 
• The lifetime cap limits how much interest fluctuates during the mortgage term. For example, if you have an initial fixed rate of 5% and a lifetime cap of 4%, your interest will never be more than 9%. Nearly all ARMs have a lifetime cap. 

With an ARM, two numbers usually represent the number of years of fixed rates and the number of adjustments of variable rates. A one for the second number means the interest rate adjusts once per year. A six means the interest rate adjusts every six months or twice a year.

For example, it might state 5/1 for five years of fixed rate followed by adjustments of variable interest rates once annually.

Common ARMs include:

• 5/1 ARM
• 5/6 ARM
• 7/1 ARM
• 7/6 ARM
• 10/1 ARM
• 10/6 ARM

Variable-Rate vs Fixed-Rate Mortgage

The difference between a variable-rate mortgage and a fixed-rate mortgage is how the interest rate is calculated and how that changes your payment schedule. With a fixed-rate mortgage, you’ll make the same monthly payments throughout the loan’s life, and your interest rate is locked in. With variable-rate mortgages, interest rates fluctuate according to loan terms in relation to a set benchmark.

In times of low interest rates, borrowers look for fixed-rate mortgages to lock in low interest rates for the duration of their 25- or 30-year mortgages. In times of high inflation, like the current markets, buyers may choose variable-rate mortgages with the hope that when interest rates drop in the future, they may have lower total payments. But this comes with risks. 

Advantages 

A variable-rate loan has significant advantages, especially with current interest rates. Here’s why you might consider these mortgages. 

Potential for Lower Payments

If interest rates decrease, the monthly payments on a variable-rate mortgage can also decrease. That means that even if your interest rate is 7%, it could drop to 5% or lower if overall interest rates drop. This is an especially attractive option when interest rates are historically high. 

Flexibility

Borrowers may have the option to make extra payments or pay off the mortgage earlier without incurring penalties. While you should always double-check terms with a lender, making payments biweekly instead of monthly means you could pay off your mortgage six to eight years earlier just by adding the equivalent of one extra payment annually (26 biweekly payments instead of 12 monthly payments). 

Refinancing Opportunities

Borrowers may be able to refinance their mortgage if interest rates drop significantly. With a variable-rate mortgage, you can secure some of the best available interest rates now, but if those change significantly, refinancing could save you even more. 

Potential Risks 

While variable-rate mortgages offer many advantages, they are not without a few significant risks, especially related to rising interest rates. Here’s what you want to consider. 

Interest Rate Uncertainty

If interest rates rise, the monthly payments can increase, potentially straining a borrower’s budget. If lenders put a maximum lifetime cap on the interest of 5%, but you’re already paying 7%, you could potentially end up paying 12% interest on your mortgage, which is a huge financial strain for most people. Learn more about how mortgage interest rates work here. 

Unpredictable Payments

Because the interest rate can change, borrowers with a variable-rate mortgage may find it difficult to budget their monthly payments. Every six months or year, you may have to adjust your budget according to changes in your mortgage interest rate. 

Potential for Higher Long-Term Costs

If interest rates rise over the long term, borrowers with variable-rate mortgages may pay more in interest than those with fixed-rate mortgages. As in the example above, starting with a high-interest rate, you’ll pay thousands of dollars extra over the loan’s lifetime if it rises. 

What to Consider 

When choosing a variable rate mortgage, it’s important to carefully consider different loan options, lenders, and your own financial situation. Here’s a checklist of points to consider. 

Explore Different Mortgage Options

Consider exploring different mortgage options before choosing a variable-rate mortgage. You may be able to secure a lower interest rate with the option of refinancing later to gain greater security. Likewise, compare lenders and get prequalified with multiple lenders to explore the best available options. 

Understand the Terms and Conditions of the Mortgage

The importance of understanding the terms and conditions of the mortgage cannot be overemphasized. Don’t be afraid to ask questions or hire a real estate attorney to help you review terms and ensure the best available option without early repayment penalties. 

Assess Your Financial Stability

Assessing your financial stability and overall financial situation with any mortgage application is important. Be careful not to overleverage yourself, build a safety net or emergency fund, and consider taking a smaller mortgage to protect yourself. 

Determine Your Risk Tolerance

When considering a variable-rate mortgage, it’s important to determine your personal risk tolerance. As variable interest rates can rise, if an increase in interest can put you at financial risk, choosing a more stable fixed-rate mortgage may be a better option.

Figure Out Your Future Plans

While you don’t have to plan the rest of your life, having a sense of your plans can factor into whether you choose a variable- or a fixed-rate mortgage. For example, the risk can be minimized if you’re taking a variable-rate mortgage with a fixed rate for the first seven years and you’re planning to move or sell the house within the next five years. Get more tips to shop for the best mortgage rates here. 

Tips

To effectively manage your variable-rate mortgage, consider the possibility of rate increases and budget accordingly. You can work to build an emergency fund or set aside an additional portion of your monthly budget for possible future rate increases.

With a variable-rate mortgage, it’s helpful to stay informed about interest rate fluctuations and market conditions to understand how they might affect your current or future rates. 

Finally, by making a larger down payment, you may be able to get a lower initial interest rate. Also, consider making biweekly mortgage payments to speed up the repayment process and build equity in the home faster. 

Choose a Lender

If you’re looking for the best mortgage rates available today, Benzinga’s trusted partners can help. Find some of the best mortgage rates here. 

When to Consider 

Variable mortgage rates offer a flexible solution for taking out a mortgage when interest rates are high. They may offer the option to lock in a lower interest rate, typically for a period of five to 10 years. Find the best mortgage rates or get the latest news on interest rates here.

Frequently Asked Questions