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Fixed Rate Mortgages • Variable Rate Mortgages

variable mortgage rates In contrast to fixed rate loans, variable rate loans (more often referred to as adjustable rate mortgages or ARMs) do not have a fixed interest rate throughout the life of the loan.  Instead, the interest rate varies according to the prevailing market rate (so if interest rates in the market fall, your interest rate falls; if interest rates in the market rise, your interest rate rises).

Here's how a variable rate mortgage works: to calculate your interest rate, your lender chooses an index rate (lenders use a variety, including treasury securities, cost of funds, the LIBOR) and then adds a margin (typically 2-3%).  As the index rate changes, your rate will change, too.

Common variable rate mortgages include the 1/1, 3/1, 5/1, 7/1, and 15/1.  A 3/1 mortgage, for example, means that your interest rate is fixed for the first three years, after which it adjusts each year.

Most variable rate mortgages are protected by an overall rate ceiling as well as interest rate increase caps or payment caps.  An overall rate ceiling sets the highest level your interest rate could go through the life of the mortgage; periodic caps limit the amount the interest rate can increase at any given time; and overall caps limit the amount the interest rate can increase over the life of the loan.  Payment caps limit the amount your payment can increase.  Beware of caps which can lead to negative amortization, where your mortgage balance is actually growing!

The advantages of a variable rate mortgage include:

  1. Your initial interest rate is likely lower than the prevailing fixed rate.  Bankrate.com is a helpful resource for checking current mortgage rates and mortgage rate trends.
  2. If you are planning to sell your house before the end of the fixed rate period, you'll probably pay less with a variable rate mortgage than with a fixed rate mortgage.
  3. You may be able to qualify for a larger loan with a variable rate mortgage than a fixed rate mortgage (because your initial interest rate is lower).
  4. If interest rates fall, you'll be able to take advantage of the new lower rates without refinancing your mortgage.

The disadvantages of a variable rate mortgage include:

  1. It will be harder to plan a long-term budget.
  2. It is more complicated to understand.  The mortgage process is difficult even with a fixed rate mortgage.  Variable rate mortgages add in another layer of complication.
  3. If interest rates rise in the future, you will have a higher monthly mortgage payment.  For that reason, variable rate mortgages are more risky: you risk not being able to afford your mortgage payments in the future.

To decide if the variable rate mortgage is right for you, the first step is to educate yourself.  A good source for more information is the Federal Reserve Board's Consumer Handbook on Adjustable-Rate Mortgages.


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