Variable-Rate Mortgage

What it is

A variable-rate mortgage (also called an adjustable-rate mortgage or ARM) is a home loan whose interest rate can change over time instead of remaining fixed for the life of the loan. Some variable-rate products are fully variable for the entire term; others are hybrid ARMs that start with a fixed-rate period and then switch to periodic adjustments (for example, a 5/1 ARM has five years fixed, then annual adjustments).

In the U.K. and parts of Europe, these products are often called tracker mortgages and typically follow a central bank base rate.

Key takeaways

• Variable-rate mortgages tie interest to a benchmark index plus a lender margin.
• Many ARMs begin with a fixed period, then adjust periodically.
• They often have lower initial payments than fixed-rate loans, but payments can rise if market rates increase.
• Borrowers who expect rates to fall or who plan to sell/refinance before large adjustments may benefit.

How it works

A variable-rate mortgage has two main components:
* Index (benchmark): a published rate such as the prime rate, a Treasury yield, or another reference rate. The lender’s chosen index determines the base fluctuation.
* Margin: a fixed number of percentage points added to the index by the lender, assigned during underwriting. A borrower’s creditworthiness often affects the margin—better credit generally yields a lower margin.

The fully indexed rate a borrower pays equals the index plus the margin. As the index changes, the fully indexed rate and monthly payments can change accordingly. Loans can be amortizing (payments repay principal and interest) or non-amortizing, depending on the product.

Many ARMs include interest-rate protections (caps) that limit how much the rate or payment can change, though the specifics vary by loan.

Common examples

• 5/1 ARM — fixed rate for five years, then adjusts annually for the remaining term.
• 2/28 ARM — fixed rate for two years, then variable for 28 years.
• 7/1 ARM — fixed for seven years, then adjusts annually thereafter.

Hybrid ARMs are often described with two numbers: the initial fixed period and the frequency or duration of the adjustable period.

What happens when rates move

If market interest rates rise, the index typically rises and so does the mortgage’s interest rate—leading to higher monthly payments. If rates fall, the borrower’s rate and payments may decrease. Caps on adjustments can reduce volatility but do not eliminate the risk of higher payments.

Pros and cons

Pros:
* Lower initial interest rate and monthly payment compared with many fixed-rate loans.
Potential savings if market rates decline.
May suit borrowers who plan to move or refinance before larger adjustments.

Cons:
* Payment uncertainty—rates and payments can rise, potentially making the loan unaffordable.
Harder to budget long-term compared with a fixed-rate mortgage.
Margin and index choices affect total cost; borrowers with lower credit may pay higher margins.

Bottom line

Variable-rate mortgages can offer lower initial costs and flexibility for borrowers who expect rates to fall or who won’t hold the loan long-term. However, because rates can increase, borrowers should understand the index, margin, adjustment frequency, and any caps before choosing a variable-rate product.