A variable rate mortgage is a type of mortgage in which the interest rate is not fixed and fluctuates in cycle with the current prime rate. Prime rate is the rate at which the commercial bank lends money to its customers. It is stated as prime plus or prime minus a percentage amount. Variable rate mortgage is usually lower than the fixed-rate mortgage.
A variable rate mortgage has fixed payments; however, changes in the interest rates affect how the payment is applied to the mortgage. If the interest rates go down, more of the payment goes to principal, and if the interest rates go up, more of the payment goes towards the interest. This interest is compounded monthly. Even though the variable interest rate may change monthly, the borrower’s monthly payments remain fixed.
A variable-rate mortgage can be a better option for an individual if:
- An individual is comfortable with the possibility of fluctuating mortgage payments
- An individual is comfortable to pay more in interest over the term of the mortgage
Variable rate mortgages come in two forms: open and closed. A closed variable mortgage binds the borrower to the terms of the mortgage for duration of 5 years. A variable open term gives the individual flexibility to move to a fixed rate at any time, but interest rates are usually higher.
The benefit of variable-rate mortgage is that the borrower can keep the monthly payment fixed even if the interest rates go up or down. The only difference is that the borrower will be paying more money out of the installment towards the interest in case the interest rate appreciates, and will be paying more money out of your installment towards the principal in case the interest rate depreciates. Thus, this type of mortgage provides the option to have a fix monthly installment but also lets the borrower reap the benefits in case the interest rate drops.
The biggest risk of variable-rate mortgages is the rise in interest rates that could lead to significantly higher interest payments, thus extending your amortization period.