Variable-Rate Mortgage

A type of mortgage which is continuously adjusted based on the interest rate in the credit markets

A Variable-Rate Mortgage, Adjustable-Rate Mortgage (ARMs), or a tracker mortgage is a type of mortgage which is continuously adjusted based on the interest rate in the credit markets. Hence, the debt is offered at a rate that can change in the future if interest rates change.

The credit markets determine the interest rate it costs a lender to loan out. Hence, variable rate mortgages are structured to allow the lender to change the rate charged to the borrower based on the market interest rate.

Usually, the market interest rate is determined by the rate on risk-free assets. An example of a risk-free asset is the United States government bonds, which are considered to have an almost negligible risk of default. 

Hence, for the lender to cover their costs and make a return on capital loaned out, an index that tracks the market interest rate is used to determine the rate the lender should charge borrowers.

The lender will use the index rate and add a "margin", this added percentage point on the rate is charged by your mortgage lender as a return on your loan. Thus, the margin varies from lender to lender and is also related to the default risk of the borrower.

A borrower with a higher default risk will be charged a much higher payment than a borrower with a low default risk, therefore, the risk that the lender takes on when financing the borrower is managed through this variance.

In the case of tracker mortgages, this rate is periodically "tracked", thus, borrowers will observe that their monthly payments will differ month to month as market rates shift.

Here are some common indexes that are used for Adjustable-Rate-Mortgages (ARMs)

  • The United States 1-Year Treasury Security: Represents the Yield offered on the United States treasury securities

  • LIBOR (London Interbank Offered Rate)

  • The Prime Rate: Rate charged to the most creditworthy borrowers for financing by lenders

  • 6-Month Certificate of Deposit (CD): Represents the interest rate on the secondary market

  • District Cost of Funds (COFI)

The London Interbank Offered Rate (LIBOR) is also quite prevalent today to set interest rates. This indicator considers the rates offered by 18 global banks in five different currencies. 

Due to serious concerns about the manipulation of the LIBOR by the rate-setting banks in the 2008 crisis, the world has largely shifted away from using this indicator to set interest rates.

Adjustable-Rate Mortgages (ARMs) have a few common structures which most lenders follow. 

Here are the different types:

 
Mortgage typeMonths fixed
10/1 ARMFixed for 120 months, adjusted annually after the end of that term up to a cap if set
7/1 ARMFixed for 84 months, adjusted annually after the end of that term up to a cap if set
5/1 ARMFixed for 60 months, adjusted annually after the end of that term
3/1 ARMFixed for 36 months, adjusted annually after the end of that term up to a cap if set
1-Year ARMFixed for 12 months, adjusted annually after the end of that term up to no cap

The types mentioned above mean that the interest rates are fixed for the borrower for the respective period after issuance. Thus, the borrower is protected against interest rate risk for that period.

However, the remaining term of the loan is adjusted annually. Therefore, the effects of a variable rate mortgage are realized after the fixed period ends.

Variable Rate Mortgages and Home Prices

There is a relationship between variable rate mortgages and home prices that borrowers, homeowners, and investors should be aware of. This section will highlight this relationship and aim to explain the factors that cause it.

It is imperative to understand that interest rates have an impact on home prices through adjustable mortgages. The reason for this is that borrowers will find that as interest rates fluctuate, the house that they can afford also changes.

Home affordability is related to the rate that lenders charge for mortgages. A borrower will find that a home is much more expensive when the interest rate charged by their lender rises if the price is then held constant. 

Hence, the rate charged by your lender for a fixed-rate or an adjustable rate loan on a home represents your cost of borrowing. That's why the cost of borrowing has a direct impact on the average prices of real estate.

Consider a situation where the United States 1 Year Treasury Yields suddenly rise due to quantitative tightening policies by the Federal Reserve. In this case, lenders will determine a much higher rate on their loans given that the risk-free rate has risen.

You can think of the lender's perspective as imagining that the baseline rate that should be charged at the minimum is going up, therefore, lenders will only find it worth it to issue more debt if they receive a higher return compared to risk-free bonds.

Hence, the market will usually observe that prices of real estate fall in the short to immediate term if the cost of borrowing has increased and so home affordability has fallen.

Example of Variable-Rate Mortgage

Variable Rate Mortgages can be difficult to understand, which is why this section will run through a hypothetical example where interest rates continue to rise. Such an example can illustrate the risk associated with an adjustable mortgage.

Imagine that you are an individual looking to purchase a home worth $2 million, you talk with your lender and find that you would need to put at least 25% down on a 30-year to be approved for an adjustable-rate mortgage. 

Here is the mortgage information:

 
Loan Amount$500,000.00
Term30 years
Starting Interest Rate5%
First Monthly Payment$2,684.11
Interest Rate Cap12%
Expected Adjustment0.25%
Rate Remains Fixed for60 months
Periods between adjustment12 months
Total Payments$1,171,550.04
Total interest$671,550.04

Notice that the lender has a strict policy on when the rates are adjusted. Moreover, there is a temporary period right after the issuance of your loan where the rate remains fixed, here, this mortgage is a 5/1 ARM because the fixed period is 60 months.

The expected adjustment on your loan refers to the increase that your lender expects on your tracker mortgage, therefore, the rate on your mortgage is expected to go up 0.25% or down 0.25% every 12 months after the fixed period is over.

This means that your lender expects that interest rates will change annually by more than or less than 0.25%. Thus, different economic environments would change lender expectations.

Additionally, there is also an interest rate cap of 12%, which means that your mortgage rate can not go over this rate, even if market rates are much higher.

Assume that unfortunately, the 30-year term of your mortgage is an increasing interest rate environment. Thus, assuming that the lender's expectations play out, the payments on your loan would look like this:

Payment NumberInterest RateMonthly Payment
15%$2,684.11
605.25%$2,751.41
725.5%$2,817.49
845.75%$2,882.26
966%$2,945.62
1086.25%$3,007.48
1206.5%$3,067.74
1326.75%$3,126.29
1447%$3,183.04
1567.25%$3,237.86
1687.5%$3,290.64
1807.75%$3,341.27
1928%$3,389.63
2048.25%$3,435.57
2168.5%$3,478.97
2288.75%$3,519.69
2409%$3,557.57
2529.25%$3,592.48
2649.5%$3,624.24
2769.75%$3,652.69
28810%$3,677.67
30010.25%$3,699.00
31210.5%$3,716.50
32410.75%$3,729.99
33611%$3,739.29
34811.25%$3,744.23

 

Notice in the table above that if interest rates continue to rise, you will observe an adjustment on your mortgage which continuously increases your monthly payments. However, such a scenario is rare and unfortunate given historical evidence of how interest rates have behaved.

Even so, this example stands to illustrate what the borrower would experience if they take out a loan in a quantitative tightening environment

Here is your payment schedule for this debt:

YearTotal PaymentsPrincipal PaidInterest PaidEnding Principal Balance
    $500,000.00
1$32,209.32$7,376.84$24,832.48$492,623.16
2$32,209.32$7,754.25$24,455.07$484,868.91
3$32,209.32$8,151.01$24,058.31$476,717.90
4$32,209.32$8,567.99$23,641.33$468,149.91
5$32,209.32$9,006.35$23,202.97$459,143.56
6$33,016.92$9,129.51$23,887.41$450,014.05
7$33,809.88$9,291.00$24,518.88$440,723.05
8$34,587.12$9,493.14$25,093.98$431,229.91
9$35,347.44$9,738.56$25,608.88$421,491.35
10$36,089.76$10,030.67$26,059.09$411,460.68
11$36,812.88$10,373.34$26,439.54$401,087.34
12$37,515.48$10,771.27$26,744.21$390,316.07
13$38,196.48$11,230.13$26,966.35$379,085.94
14$38,854.32$11,756.14$27,098.18$367,329.80
15$39,487.68$12,356.98$27,130.70$354,972.82
16$40,095.24$13,041.63$27,053.61$341,931.19
17$40,675.56$13,820.52$26,855.04$328,110.67
18$41,226.84$14,705.51$26,521.33$313,405.16
19$41,747.64$15,710.91$26,036.73$297,694.25
20$42,236.28$16,853.29$25,382.99$280,840.96
21$42,690.84$18,151.79$24,539.05$262,689.17
22$43,109.76$19,629.37$23,480.39$243,059.80
23$43,490.88$21,312.32$22,178.56$221,747.48
24$43,832.28$23,231.87$20,600.41$198,515.61
25$44,132.04$25,424.83$18,707.21$173,090.78
26$44,388.00$27,934.35$16,453.65$145,156.43
27$44,598.00$30,811.39$13,786.61$114,345.04
28$44,759.88$34,116.24$10,643.64$80,228.80
29$44,871.48$37,920.31$6,951.17$42,308.49
30$44,930.76$42,308.49$2,622.27$0.00

 

Remember that our example illustrates what your loan payments and structure would look like in a rising rates environment. Consult with your lender to understand their expectations on interest rates to determine if you should apply for a variable mortgage.

Feel free to use the calculator on Bankrate for variable rate mortgages to do a rough calculation on how your mortgage can play out based on your assumption

Advantages and Disadvantages of Variable Rate Mortgages

There are many drawbacks and benefits associated with a variable rate or ARM that borrowers should be aware of. This section will highlight these factors and discuss them in detail.

Here is a table below that summarizes the factors related to a tracker mortgage:

 
AdvantagesDisadvantages
Usually, initial interest payments are lower than other mortgage options such as fixed rate mortgagesMonthly payments fluctuate from year to year if rates are adjusted annually
Works well in a low and stable or falling interest rate environment as a larger chunk of your payment applies to the principalCan get costly in a rising interest rate environment as less of the payment applies to the principal
Fixed rate for a certain period after issuance means low payments for that temporary periodDifficult to forecast future financial standing of the mortgage because of fluctuating interest rates
Payment caps to protect borrowerNegative amortization if market interest rates are above cap rate

Negative amortization refers to the situation where the loan payments made are less than the interest rate charged over that term.  means that the outstanding balance of the loan  or what you owe the lender increases.

Imagine that you have a 10/1 ARM, this means that your rates are fixed for 10 years before adjustment. Now, if interest rates rise to 14% and the adjustment cap of your mortgage is 11%, then the difference in that payment applies to your outstanding balance.

Hence, there are pitfalls associated with caps, even if they serve to protect you from unusually high-interest rates. When your interest rates are capped, the lender will apply the difference in interest that you owe to your balance. 

This means your balance may increase every month even while you are making full payments.  Therefore, caps serve to protect the borrower temporarily from high rates by capping the highest possible monthly payment.

Given the risks associated with adjustable mortgages, you should explore the worst-case scenario with your lender and analyze if you will still be able to comfortably make payments if that plays out.

Lenders are aware of these risks, and they give borrowers a fixed period for an adjustable rate after issuance where the rate on the mortgage is temporarily free from an adjustment. This can protect borrowers if interest rates were to unexpectedly increase over that period.

Further, if you conduct an analysis and find that interest rates are likely to be stable or fall in the future, then you can opt for an adjustable-rate to benefit from falling borrowing costs. This means that your monthly payments would fall annually after adjustment.

If you're thinking about applying for a Variable Rate mortgage, feel free to read the Consumer Handbook on Adjustable Rate Mortgages (CHARM) booklet. This may answer many queries related to the application process and how your mortgage may work.

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Research and authored by Imran Husain Linkedin

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