Variable Rate Mortgage

Definition

A Variable Rate Mortgage, also known as an adjustable-rate mortgage, is a type of home loan where the interest rate adjusts over time based on market conditions. The interest rate may increase or decrease during the loan term, typically based on changes in a reference interest rate. This change makes the monthly repayments unpredictable.

Phonetic

The phonetics of the keyword “Variable Rate Mortgage” is: ˈveəriəbəl reit ˈmɔːɡɪdʒ

Key Takeaways

1. Fluctuating Interest Rate– Variable rate mortgages often come with interest rates that fluctuate over time. These fluctuating rates depend on the market prime rate, which is determined by various factors such as the federal interest rate and lenders’ costs.
2. Potential Lower Costs– In many cases, initial interest rates for variable rate mortgages can be lower than those of fixed rate mortgages. This means that if the prime rate doesn’t increase significantly, you could potentially pay less overall compared to a fixed rate mortgage.
3. Risk Factor– While a variable rate mortgage can offer potential savings, it also carries more risk. If interest rates rise, your monthly payments can increase. If you are considering this type of mortgage, make sure you are financially prepared for possible increases in your mortgage payments.

Importance

A Variable Rate Mortgage, also known as an Adjustable Rate Mortgage, is crucial in the field of business and finance as it provides borrowers and investors with a degree of flexibility. This type of mortgage ties the interest rate to a benchmark or index, which often changes over time, allowing the interest rate and subsequently, the mortgage payments, to adjust periodically. Borrowers can potentially benefit from lower initial interest rates compared to fixed-rate mortgages and can take advantage if rates drop over time. However, they also bear the risk of increased payments if rates rise. Therefore, understanding Variable Rate Mortgages is key in making informed, strategic decisions in property investment and financing.

Explanation

A Variable Rate Mortgage, also known as an adjustable rate mortgage, serves as a type of home loan where the interest rates fluctuate over time. This is mainly tied to changes in an index that reflects cost changes for lenders, which is predicated on market changes. Essentially, if the lender’s cost of borrowing money decreases or increases, the variable rate of the mortgage will also decrease or increase correspondingly. This system’s primary purpose is to distribute the risk of market fluctuations between the lender and the borrower instead of it being shouldered entirely by one party. For individuals considering a variable rate mortgage, this type of loan can be particularly beneficial in a decreasing interest rate environment because their interest rates will decline along with overall rate decreases. Thus, borrowers can reap the advantage of paying lower interest rates without having to refinance their home loans. This benefits borrowers by giving them room to manage their monthly budget more flexibly. Furthermore, variable rate mortgages often carry lower initial interest rates, which can make it easier for homebuyers to qualify for larger loan amounts. However, borrowers must be comfortable with the risk that their rates (and therefore payment amounts) may increase in the future.

Examples

1. John and Susan’s Home Purchase: John and Susan needed to purchase a home but didn’t want to get locked into a high interest rate as they believe the rates would drop in the next few years. So, they opted for a variable rate mortgage. When they took out the mortgage, the interest rate was 5%, but after two years it dropped to 4% due to changes in the local economy. This allowed them to save significantly on their monthly mortgage payments. 2. Emily’s Real Estate Investment: Emily is a real estate investor who usually flips homes for profit within a short span of time. Rather than taking a fixed rate mortgage, she prefers variable rate mortgages due to the potential financial advantage if interest rates decrease. Even though there’s a risk of rates rising, she’s comfortable with it, as she intends to resell the property within a few years. 3. Construction Company’s Large Scale Projects: A construction company acquired a multi-million dollar contract to complete a large-scale project in 5 years. Based on past patterns, they predict that interest rates will decline in the next few years. To finance the project, they choose a variable rate mortgage, enabling them to take advantage of potential future lower rates, thus reducing their total debt cost over the length of the project.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Adjustable-Rate Mortgage (ARM)
• Interest Rate Cap Structure
• Index Rate
• Amortization Schedule
• Mortgage Margin

Sources for More Information

• Investopedia
• Corporate Finance Institute
• WallStreetMojo
• Credit Karma