What is a variable-rate mortgage?

Your mortgage’s interest rate could change — for better or worse.

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Whether you’re applying for a government-backed loan or a conventional mortgage, you’ll likely have the choice between a fixed or variable interest rate.

Although a fixed-rate is typically safer, variable-rate mortgages may be an excellent option for some homebuyers.

They often have a low, fixed-rate introductory period, meaning you could have lower monthly payments at the beginning of your loan. A lower initial interest rate could be advantageous if you plan to pay extra on the principal during this time or move before the first rate adjustment.

Key insights

A variable-rate mortgage is a type of mortgage where the interest rate can adjust up or down depending on market conditions.

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Many lenders offer hybrid mortgages that start out with a fixed rate but switch to a variable rate once the introductory term is over.

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While your rate could drop with a variable-rate mortgage, it could also increase, resulting in higher monthly mortgage payments and possibly more interest in the long run.

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How variable-rate mortgages work

A variable-rate mortgage, often called an adjustable-rate mortgage (ARM), is a type of home loan whose interest rate can change periodically.

Several types of financial products will use variable interest rates, including student loans, home equity lines of credit (HELOCs), credit cards and personal lines of credit.

Qualifications for variable-rate mortgages vary between lenders. However, many consider your employment history, income, credit score and debt-to-income ratio (DTI). Most mortgage lenders also require a minimum down payment between 3% to 5%.

Variable-rate mortgage vs. fixed-rate mortgage

While the interest rate on a variable-rate mortgage can change, a fixed-rate mortgage maintains a consistent rate throughout the entire loan.

Your monthly payment will always be the same with a fixed-rate mortgage. It can be a safer and more predictable approach for borrowers.

Although you may pay less initially with a variable-rate mortgage, it can be more risky because your interest rate and monthly payment could rise once the introductory period ends.

» MORE: What is a conventional mortgage?

How variable rates are determined

Now that you understand how variable-rate mortgages work, let's look at how mortgage rates are determined.

If you opt for a hybrid mortgage, you’ll have an initial fixed-rate period before the rate becomes variable. For example, a 5/1 ARM has a fixed rate for the first five years and can be adjusted annually afterward.

When it’s time for your rate to adjust, the lender looks at their chosen index that reflects overall market conditions. Common indexes include the U.S. Prime Rate, the London Interbank Offered Rate (LIBOR) and the Cost of Funds Index (COFI).

The lender then adds the margin — an additional percentage to cover costs and profit margins — to the index to determine your interest rate.

However, variable-rate mortgages typically have interest rate caps, meaning your rate won’t exceed the amount listed in your loan agreement.

Pros and cons of variable-rate mortgages

Under the right circumstances, a variable-rate mortgage can be an excellent option for homebuyers. Some variable-rate mortgages may include a fixed-rate period at the beginning of the loan. The introductory rate is often lower than what you would get with a fixed-rate mortgage. However, unlike a fixed-rate mortgage, your interest rate and monthly payment are not guaranteed to stay the same. This uncertainty can make it challenging to plan for the future.

Consider these pros and cons before choosing a variable-rate mortgage.

Pros

  • Low introductory rate
  • Rates may drop
  • Better for short-term loans

Cons

  • Unpredictable rates and payments
  • Rates may increase
  • More complex

Is a variable-rate mortgage right for you?

Before choosing a variable-rate mortgage, you should consider your current and possible future financial situation.

“I had a close friend who opted for a variable-rate mortgage to capitalize on the lower initial rates, driven by a stable job in a growing tech company and the assumption of continued low market rates,” said Larry Zhong, a licensed FINRA financial advisor and founder of YieldAlley.

“Two years into the mortgage, when the Fed raised interest rates to combat inflation, my friend was shocked to see a significant increase in his monthly payments. This adjustment strained his budget, as it coincided with unexpected job instability in the tech sector.”

While a low introductory rate may be appealing, it's important to factor in your risk tolerance and potential unexpected hardships, such as job loss, medical issues or poor market conditions.

“One crucial piece of advice that emerged from my friend's experience is it's important to understand how various interest rate scenarios can impact your monthly payments before choosing a variable-rate mortgage,” continued Zhong. “Making an informed choice requires looking beyond immediate benefits and preparing for various future scenarios.”

View rates from leading lenders now.

    FAQ

    Can I switch from a variable-rate mortgage to a fixed-rate mortgage?

    Typically, you can switch from a variable to a fixed-rate mortgage. You just need to contact your lender to let them know.

    How often do variable-rate mortgage interest rates change?

    The frequency of interest rate changes for a variable-rate mortgage depends on the loan agreement. For example, with a 5/1 ARM, the interest rate is fixed for five years and then adjusted annually.

    What happens if interest rates rise substantially?

    Lenders typically have interest rate caps on variable-rate mortgages. While your rate will likely increase if rates rise substantially, it will never exceed your interest rate caps.

    Bottom line

    Although variable-rate mortgages carry some risks, these types of mortgage loans may prove beneficial for homebuyers who expect interest rates to decline or who plan to move before the introductory period ends.

    However, always review the loan estimate to ensure you can meet the maximum monthly payments in case of future financial challenges, such as increased interest rates, job loss or medical issues.

    Mortgage lender credits may be another option if you simply want to save money upfront on your home purchase.


    Article sources

    ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:

    1. Consumer Financial Protection Bureau, “Determine your down payment.” Accessed March 8, 2024
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