Variable-Rate Mortgage: Advantages And Disadvantages
Buying a property is a significant financial commitment. You have many factors to consider, such as location, price, and size. Probably the most crucial consideration is what kind of home loan is best for you. Today, we’ll learn how an adjustable-rate mortgage works and when it might be the way to finance your house.
Variable Rates Explained
A variable-rate mortgage, also known as adjustable-rate mortgage (ARM), means that the monthly interest you pay fluctuates over the life of your loan. Depending on how financial market conditions evolve, the interest charged can also change.
However, as your principal balance comes down, the monthly interest also gradually falls. This amount depends on economic benchmarks, such as the Federal Reserve’s prime rate. When the index falls, the interest margin will also decrease. Most ARMs have fences known as caps limiting how much this margin can rise or fall.
Variable-Rate Vs. Fixed-Rate
The total sum you borrow to buy your home will be the same whether you choose a fixed or variable rate mortgage. However, how much you spend out of pocket over the life of the loan will be different.
- The interest rate is locked in. It doesn’t change
- Your monthly payment is the same for the life of your loan
- If the APR was high when you took out the loan, and now it’s fallen, you’ll want to refinance
- The interest floats
- After an initial payment period, your monthly payment becomes unpredictable
- The principal amount remains the same, but the interest fluctuates
- If APRs fall, you’ll benefit without having to refinance
How Variable Rate Mortgages Work
Let’s assume that you want to buy a home. Unless you have cash, you’ll need a mortgage. The home you intend to purchase collateralizes the loan. Most repayment terms are for 30 years, but there are also 15-year and 20-year loan durations.
For example, maybe you can take a lending product fixed at 4.1%, but you opt for a 5/1 ARM at 3.5%. Hence, your interest margin is better than the fixed financing option.
The “5/1” means that the interest will remain at 3.5% for the first five years. Thereafter, this figure will be adjusted annually based on changes in the Treasury index. If you sell the house within five years, you’ll make out better than if you had taken a loan with a fixed APR at a higher interest rate.
The fixed period on most variable-rate mortgages is three, five, or seven years. You’ll see this written on your loan document as 3/1, 5/1, or 7/1.
Caps set a limit on how much the APR can fall and how much it can rise. These amounts are adjusted based on a predetermined figure set monthly by the Treasury Average Index or the LIBOR.
What Are The Advantages?
You may choose an ARM for reasons such as:
- In the beginning, variable home interest rates can be lower than fixed financing options
- It’s easier to qualify
- Since the monthly payments during the initial fixed period are lower, you can buy a more expensive home
- If you intend to sell your home or refinance before the initial locked-in period is over, you’ll benefit from lower monthly payments than you would if you had taken a loan with a fixed APR
- If your income fluctuates, the flexibility of these mortgages works to your advantage. For instance, if you receive bonuses or commissions, you can make lump-sum payments throughout the year
- When interest margins come down, you’ll benefit without needing to refinance your mortgage
Disadvantages Of Variable-Rate Mortgages
- ARMs aren’t for everyone
- These home loans are risky. There’s no way to predict what the interest margins will do
- After the initial locked-in period is over, your lending product could become expensive
- There’s no way to know what your monthly payments will be. Therefore, it’s challenging to create a budget and strategy for managing your finances
- Even with an interest cap, the cost of the loan could reach a point where you can’t handle the monthly payment
- Understanding how this type of financing works can be challenging. The terms and mechanisms can be confusing. For instance, the terms cap, ceiling, adjustment frequency, adjustment index needs to be understood
The Bottom Line
If you like to gamble or have a talent for predicting interest margins, a variable rate mortgage could be an excellent way to buy your home. You’ll qualify for a more expensive house and benefit from a lower APR.
If you envision that your income will grow, the potentially higher monthly payments won’t be a problem. However, the calculations behind how a variable-rate mortgage works are more complicated.
Before deciding, be sure you understand the process and its methodologies.