What is a Variable Rate Mortgage?

Definition of a Variable Rate Mortgage

A variable rate mortgage is a mortgage where the interest rate may change periodically during the term of the mortgage, but the monthly payment of the borrower will remain the same. As a result you could end up paying more or less towards the principal of your mortgage depending on the interest rate. If the interest rate increases, the amount applied to the principal will decrease. If the interest rate decreases, the amount applied to the principal will increase.

Sometimes a variable rate mortgage is confused with an adjustable rate mortgage, but they are not the same. In an adjustable rate mortgage, if the interest rate rises, the borrower’s monthly payment will rise. With a variable rate mortgage, the monthly payment stays the same.

Example

Mr. McGillicuddy has a mortgage of $200,000 at 5% interest, 30 year amortization and a payment of $1067. After approximately a year of payments, roughly $813.00 would be applied to interest and $254 would be applied to decrease the principal of the mortgage.

After a year, due to market changes, the interest rate is increased to 6%. In an adjustable rate mortgage, Mr. McGillicuddy’s payment would got up to $1,189. In a variable rate mortgage, the borrower’s payment would remain the same, but the amount applied to principal would fall to roughly $234.

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Advantages of a Variable Rate Mortgage

The initial interest rate of a variable rate mortgage is usually lower than a fixed rate mortgage. If interest rates rise and the monthly payment does not increase. Therefore, this can be a good option for a borrower on a tight monthly budget as they can be reasonably assured that they could still afford the payments.

Disadvantages of a Variable Rate Mortgage

If interest rates rise, less of the borrower’s monthly payment will go towards the mortgage principal, meaning it takes longer to repay the mortgage. If interest rates rise high enough, the borrower may end up in a negative amortization situation, where the monthly payment is insufficient to cover the monthly interest accrued. However, most lenders will allow you to lock into the best fixed interest rate available if you so choose.

At First Foundation, we understand that there is no such thing as a “one size fits all” mortgage. Different customers have different goals and different needs. That is why we provide a number of different mortgage products so we can help you determine what best meet your needs.

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Last updated Apr 23, 2014