What is a Variable Rate Mortgage?
A variable rate mortgage is a mortgage with an interest rate that may change periodically, based on market conditions. Variable-rate mortgages typically have a lower interest rate than fixed-rate mortgages, but that rate is not guaranteed for the length of the mortgage term.
There are two types of variable-rate mortgages, those with variable payments and those with fixed monthly payments. If a homeowner has a variable rate mortgage with a variable payment, their monthly payments will rise, or lower, along with the interest rate. If they have fixed monthly payments, the dollar value of the payments will remain the same but the amount going towards the interest and principal will fluctuate.
Why is this term important?
Understanding how variable rate mortgages operate is important when choosing which mortgage product is best for a homeowner’s unique situation. If a homeowner chooses a variable rate mortgage then should be prepared to pay close attention to any changes to interest rates as they may impact their monthly payments or the amortization schedule of their mortgage.
Here is an example:
Let’s say a homeowner is choosing between a 5-year fixed or variable-rate mortgage.
The fixed mortgage rate offered at the time is 3.50%, with monthly payments of $2,240, while the variable rate mortgage is 3% and has monthly payments of $2,000. With a variable mortgage rate, the monthly payments are $240 lower every month, allowing the homeowner to have more financial flexibility.
But, with a variable-rate mortgage, things are subject to change. Let’s say, over time, the interest rate has increased by 0.5% to 3.5%
If the homeowner has variable payments, their monthly payments would increase to match the interest rate increase. But, if they have fixed monthly payments, their monthly payment would remain at $2,000. However, more of the payment would be used to pay the increased interest, meaning less would be used to lower the outstanding mortgage loan and it will take longer to pay off the mortgage in full.