What is a variable rate mortgage, and how is it different from fixed-rate mortgages?

What is a variable-rate mortgage? Learn the ins and outs of this financing option and compare it with fixed-rate mortgages

By Jesse Oberoi, CFA

•

23 October 2023

When it comes to mortgages, one of the most critical decisions you have to make is choosing between a variable-rate mortgage or a fixed-rate mortgage.

Neither is better than the other, but each has a particular set of advantages, drawbacks, and unique features. Your financial situation, beliefs, and emotional profile can influence which type is best for you.

Over the next few minutes, this article will answer the question: what is a variable rate mortgage, and how is it different from a fixed rate mortgage?

Make sure to read to the end to learn about five factors that will help you choose between the two.

What is a variable rate mortgage?

A variable rate mortgage—commonly referred to as an adjustable-rate mortgage (ARM) in the United States—is a type of home loan with a potentially fluctuating interest rate.

Over the life of the loan, the rate can change and go up or down based on a particular index.

The federal funds rate is typically used as the reference benchmark or index. It’s the target interest rate set by the Federal Open Market Committee (FOMC) and used by commercial banks when borrowing and lending excess reserves to one another overnight.

How does a variable rate mortgage work?

Initial period: A variable-rate mortgage will start with a fixed interest rate. That is, the bank will approve you for an initial fixed rate mortgage at 5.5%, for example. From there, the interest rate can rise or fall depending on the reference benchmark or index.
Adjustment period: Following the initial period, the interest rate will adjust at predetermined intervals, such as quarterly.
Rate calculation: Variable rates are usually adjusted based on a reference rate. Typically, the lender will add a margin to the interest rate. For example, if the Fed Funds Rate is 6%, then your mortgage rate might be 6.5%. This difference represents a portion of the profit the lender hopes to generate.
Rate caps: Most variable rate mortgages have a maximum limit or “cap” on how much interest rates can change each period. In addition to each period cap, there may also be a lifetime maximum interest rate that can be charged.

Pros and cons of variable rate mortgages

Pros

Variable rates are almost always lower than fixed rates at the loan's outset.
Borrowers will benefit from lower rates and payments if the Fed lowers interest rates.
Many variable-rate mortgages enjoy rate caps that limit your potential interest costs.

Cons

If the Fed hikes interest rates, variable-rate borrowers will likely see their payments rise.
Variable-rate mortgages are less predictable than their fixed-rate counterparts. As a result, they can be more challenging to budget.
Variable-rate mortgages are more complex and difficult to understand than fixed-rate loans.
In extreme scenarios, variable-rate mortgages can lead to negative amortization. This results when minimum payments are insufficient to cover even the interest portion of the monthly obligation.

What is a fixed-rate mortgage?

Unlike a variable-rate mortgage, where the rate can fluctuate, the interest rates of fixed-rate mortgages remain constant for the duration of the loan. As a result, monthly principal and interest are predictable.

Pros and cons of fixed-rate mortgages

Pros

Monthly payments are predictable. This makes budgeting more straightforward.
Fixed-rate mortgages protect you from rising interest rates. Even when Federal Reserve hikes occur, your rate is locked in, so you won’t be impacted.
Fixed-rate mortgages are more straightforward and easier to understand.
The stability of payments offers peace of mind for borrowers who want to avoid surprises.

Cons

Usually, a higher initial interest rate compared to a variable structure.
Potential to miss out on lower rates if the Fed pivots lower.

Variable vs fixed: What type of mortgage should you choose?

This is the million-dollar question that every homebuyer has to grapple with and there's no straightforward answer. But, there are several factors to consider, including what most matters to you, that will help you weigh which type of loan is best for you.

Predictability: Do you prefer predictable and consistent payments, as with fixed rates? Or are you just as comfortable with potentially fluctuating rates throughout the life of your mortgage?
Initial lower rate: Do you want to take advantage of the typically lower interest rates that initially come with variable-rate loans? Or are you okay with accepting slightly higher interest to lock in a rate?
Timeline: Do you plan on selling this property within the next few years? If so, a variable rate might make more sense because the Federal Reserve has a shorter time frame to hike rates. The longer the time horizon, the less predictable the economic environment.
Risk appetite: Are you risk averse? Does the thought of rates rising stress you out? If so, consider a fixed rate. Alternatively, if you have a high-risk tolerance and can financially handle payment fluctuation, variable likely makes more sense.
Economic outlook: This is the most critical factor on the list. If you believe rates will rise substantially, locking in a rate now makes sense. If, however, you expect rates to fall, you may as well take advantage of a variable structure. Nothing is guaranteed, but many people believe the Fed is mostly done with the aggressive rate-tightening campaign it enacted over the past two years. If you believe the predictions from these economists, rates have peaked and will soon begin to fall.

With a clear understanding of a variable rate mortgage, you’ve taken the first step to confidently navigating the complex mortgage landscape.

As you now know, the choice between a variable and fixed rate doesn’t boil down to a one-size-fits-all answer. Instead, it relies on a careful assessment of your risk appetite, financial goals, and even predictions about the future of the economy.

Nevertheless, staying informed and consulting experts for advice is prudent in this rapidly evolving economic landscape.

Doing so will help ensure you make a decision consistent with your objectives and one that will deliver the best possible financial outcome.