Variable Rate Mortgage

A mortgage in which the interest rate is adjusted periodically based on an index. Also known as a renegotiable rate mortgage, a Canadian rollover mortgage and an adjustable rate mortgage (ARM).

A variable rate mortgage often has a lower initial interest rate than a fixed mortgage. With a variable rate mortgage, however, the initial rate changes after a period of time. Once that period is over, the interest rate of a variable rate mortgage rises or falls depending on an index. This usually occurs every year over the term of the loan, but it depends on the adjustment interval specific to your loan. With a variable rate mortgage, you run the risk that interest rates will go up, causing your mortgage payment to increase.

The interest rate of a variable rate mortgage changes, or adjusts, based on an index. An index is a published interest rate based on the returns of investments such as U.S. Treasury securities. The rates for these investments change in response to market conditions, so an index tends to track to changes in U.S. or world interest rates.

Variable rate mortgages often have a rate adjustment cap that limits the size of the initial rate adjustment and another cap that limits the size of subsequent rate adjustments. Caps refer to a legally required maximum on how much the interest rate of a variable rate mortgage can increase over the life of the loan. The overall cap limits the interest rate for the entire life of the loan. The periodic cap limits how much the interest rate can increase at each adjustment period. This protects you from your interest rate making a huge jump after one year.

Say the index rate rises from 2.5 percent to 5.5 percent during an adjustment period. That would make the interest rate of 4.5 percent rise to 7.5 percent. However, a 2 percent cap would keep the interest rate at 6.5 percent. This keeps the borrower from having too sharp an increase in his/her rate.

A variable rate mortgage can be appealing. The initial lower interest rate means your mortgage payment will be lower at first. If you know that you will move before your rates begin to change, that you can refinance before your rate adjusts, or are certain that you will be able to handle a higher interest rate in the future, a variable rate mortgage may be right for you.

However, you do need to carefully consider the consequences when deciding whether or not to get a variable rate mortgage. If interest rates are expected to drop in the foreseeable future, an ARM becomes more appealing. If interest rates are expected to rise, it becomes more costly. An upcoming car loan or student loans can make an ARM more risky, as it may make it harder to make the mortgage payment if there is a rate increase. In addition, if your job situation is not secure, a variable rate mortgage can be just too risky.

When deciding whether to get a variable rate mortgage, calculate the highest payment you can afford without putting too much financial stress on yourself. Figure out how high interest rates will have to go to reach that point. If interest rates are likely to get that high, an ARM might not be right for you. If you have some wiggle room and/or the chance to sell or refinance before that point, a variable rate mortgage could save you money in monthly payments and might be a good option to consider.