Variable-Rate Mortgage

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

Author: Imran Husain
Imran Husain
Imran Husain
Imran Husain, who recently graduated from the University of Toronto with a degree in Rotman Commerce specializing in Finance and a minor in Economics, is set to join Turner and Townsend in Infrastructure Consulting. His experience includes roles in real estate analysis at Hi-lo Investments, a stint at Brookfield Properties, and serving as a Financial Research Analyst at Wall Street Oasis. Imran's leaded as Vice President of the Rotman Commerce Real Estate Association, where he organized events and engaged with industry leaders. Alongside real estate development case competitions during his time at school.
Reviewed By: Celine Khattar
Celine Khattar
Celine Khattar
Coming from a background in Financial Engineering, Céline is a Financial Writer with 2+ years of experience in the Fintech industry. Currently based in the UAE, she covers diverse topics within the space, and is constantly following the latest market news and developments.
Last Updated:June 8, 2024

What Is a Variable Rate Mortgage?

A Variable-Rate Mortgage, Adjustable-Rate Mortgage (ARM), or tracker mortgage is a type of mortgage that 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 a lender charges for loans. 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,” which is an additional percentage point on the rate 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 borrower's default risk.

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

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 that most lenders follow. 

Here are the different types:

Mortgage type Months fixed
10/1 ARM Fixed for 120 months, adjusted annually after the end of that term up to a cap if set
7/1 ARM Fixed for 84 months, adjusted annually after the end of that term up to a cap if set
5/1 ARM Fixed for 60 months, adjusted annually after the end of that term
3/1 ARM Fixed for 36 months, adjusted annually after the end of that term up to a cap if set
1-Year ARM Fixed 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.

Key Takeaways

  • A variable rate mortgage (VRM), also known as an adjustable-rate mortgage (ARM), is a home loan with an interest rate that can change periodically based on the performance of a specific benchmark or index.
  • Many VRMs start with an initial fixed-rate period, during which the interest rate remains constant for a certain period (commonly 3, 5, 7, or 10 years). After this period, the rate begins to adjust periodically.
  • After the initial fixed-rate period, the interest rate on a VRM adjusts at regular intervals, which can be monthly, semi-annually, or annually, depending on the loan terms.
  • Broader economic conditions and monetary policy influence the interest rate on a VRM. Central bank interest rates, inflation, and economic growth can all impact the benchmark rates that VRMs are tied to.

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 the Federal Reserve's quantitative tightening policies. Given that the risk-free rate has risen, lenders will determine a much higher rate on their loans.

You can think of the lender's perspective as imagining that the minimum baseline rate that should be charged 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 mortgage to be approved for an adjustable-rate mortgage. 

Here is the mortgage information:

Loan Amount $500,000.00
Term 30 years
Starting Interest Rate 5%
First Monthly Payment $2,684.11
Interest Rate Cap 12%
Expected Adjustment 0.25%
Rate Remains Fixed for 60 months
Periods between adjustment 12 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 an interest rate cap of 12%, which means that your mortgage rate can not exceed this cap, 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 Number Interest Rate Monthly Payment
1 5% $2,684.11
60 5.25% $2,751.41
72 5.5% $2,817.49
84 5.75% $2,882.26
96 6% $2,945.62
108 6.25% $3,007.48
120 6.5% $3,067.74
132 6.75% $3,126.29
144 7% $3,183.04
156 7.25% $3,237.86
168 7.5% $3,290.64
180 7.75% $3,341.27
192 8% $3,389.63
204 8.25% $3,435.57
216 8.5% $3,478.97
228 8.75% $3,519.69
240 9% $3,557.57
252 9.25% $3,592.48
264 9.5% $3,624.24
276 9.75% $3,652.69
288 10% $3,677.67
300 10.25% $3,699.00
312 10.5% $3,716.50
324 10.75% $3,729.99
336 11% $3,739.29
348 11.25% $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:

Year Total Payments Principal Paid Interest Paid Ending Principal Balance
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:

Advantages And Disadvantages Of Variable-Rate Mortgage
Advantages Disadvantages
Usually, initial interest payments are lower than other mortgage options, such as fixed-rate mortgages Monthly 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 principal Can get costly in a rising interest rate environment as less of the payment applies to the principal
A fixed rate for a certain period after issuance means low payments for that temporary period Difficult to forecast the future financial standing of the mortgage because of fluctuating interest rates
Payment caps to protect the borrower Negative amortization if market interest rates are above the 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, caps have pitfalls, even if they 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 make payments if that plays out comfortably.

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

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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