Defining the Variable Rate Mortgage

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A Variable Rate Mortgage (VRM), also known as an adjustable rate mortgage (ARM) or floating rate mortgage, is a mortgage loan in which the interest adjusts to reflect the current economic conditions.

Rates

In general, Variable Rate Mortgage contracts begin with rates that are lower than fixed rate mortgages because of the risk involved. At the end of the adjustment interval, the interest rate is either raised or lowered according to the economic index to which the rate is tied. The interest rate at the start of the loan will depend on the terms that are negotiated at loan origination.

Most VRMs have limits (a cap) on how many percentage points the interest can increased in any one adjustment period, as well as over the life of the loan. The inherent risk in this type of loan is that the interest rate can swell to the maximum amount allowed for an interval, and then readjust upward again at the end of the next interval. Even if the interest rate has a cap on how much it can increase over the life of the loan, that number can be reached quickly and remain in place.

The appealing aspect of an adjustable rate mortgage is that the interest rate may go lower than the starting rate, and stay there for the life of the loan. Also, with some mortgages, because the principle is being paid (albeit slowly), when the new interest rate is figured, it is applied to the lower principle amount.

Variations on the theme

Not all variable rate mortgages operate along these lines. One type, known as an Option ARM, or a flexible payment ARM, has an interest rate that adjusts every month with no adjustment caps. In the beginning, these loans have very low mortgage payments, but rise over time, and sometimes drastically.

Hybrid ARMs are also available. With this type, the interest rate is fixed for a period of time. At the end of that time, it becomes a variable rate with scheduled reset dates.

Borrowers with good credit, who are current on all payments and fees, may be able to refinance their loan from an adjustable rate to a fixed rate. By carefully monitoring interest rates, a homeowner may decide that the interest rate that will be assessed at the reset point will be too high. By refinancing to a fixed rate loan, the borrower in essence replaces the original variable rate mortgage, and the uncertainty surrounding interest rates, with the security of a set interest rate, though it may be a little higher.