Definition
A Variable-Rate Mortgage (VRM), also known as an Adjustable-Rate Mortgage (ARM), is a type of long-term mortgage loan with interest rates that periodically adjust based on an underlying financial index tied to market conditions. Typically, the interest rate can change every six months. The adjustments reflect changes in market interest rates and often come with caps to limit the degree and frequency of rate increases.
Key Attributes:
- Adjustment Frequency: Generally every 6 months.
- Annual Increase Cap: No more than ½ point.
- Lifetime Increase Cap: Cannot exceed 2½ points over the life of the loan.
Examples
Example 1:
Abel secures a Variable-Rate Mortgage at an interest rate of 6%. After six months, the index the mortgage is tied to increases by 1 percentage point. Consequently, Abel’s interest rate adjusts to 6½%. Due to the annual cap, his rate cannot increase further during that year, even if market rates rise more.
Example 2:
Brenda has a VRM with an initial rate of 5%. Over the next five years, adjustments are made biannually based on the market index. The rate increases modestly until the fifth-year cap of a total 2½ points to reach an 7.5% rate, beyond which it can no longer rise based on contractual limits.
Frequently Asked Questions (FAQs)
What is the main advantage of a Variable-Rate Mortgage?
The primary advantage is that the initial interest rates of VRMs are typically lower than the interest rates offered on fixed-rate mortgages. This can result in lower initial monthly payments.
How often do the interest rates on VRMs adjust?
Interest rates on VRMs commonly adjust every six months, but this period can vary based on mortgage terms.
What are caps in the context of VRMs?
Caps are the limits set on how much the interest rates can adjust, both annually and over the life of the loan. They are designed to prevent excessive increases in interest rates, providing some protection to the borrower.
How is the adjusted interest rate calculated?
The adjusted interest rate is calculated by adding a set margin, determined at the inception of the loan, to the current index rate. For example, if the agreed margin is 2% and the index rate is currently 5%, the adjusted rate would be 7%.
Are VRMs better suited for short-term or long-term homebuyers?
VRMs are often better suited for short-term homeowners who plan to sell or refinance before significant rate adjustments occur.
Related Terms
Adjustable-Rate Mortgage (ARM)
A mortgage with an initial fixed rate period that resets periodically based on the performance of a specific benchmark or index.
Fixed-Rate Mortgage (FRM)
A mortgage with a fixed interest rate that remains the same throughout the entire term of the loan, providing predictability in monthly payments.
Interest Rate Caps
Limits put in place within adjustable-rate mortgages and loans to control the amount that the interest rate can adjust at any single adjustment period to prevent excessive increases.
Index Rate
A benchmark interest rate that reflects the cost to borrow funds in the open market. Common indices include the London Interbank Offered Rate (LIBOR) or U.S. Treasury rates.
Online Resources
- Consumer Financial Protection Bureau (CFPB)
- Investopedia Article on ARMs
- Federal Reserve’s Mortgage Comparison Tool
References
- “Adjustable Rate Mortgages”, Investopedia. Wilton, Roger. Accessed November 12, 2021. Link
- “Your Home Loan Toolkit: A Step-by-Step Guide,” Bureau of Consumer Financial Protection. Available at CFPB Guide
- “Adjustable Rate Mortgage Payment Calculator”, Bankrate. Accessed October 11, 2021. Link
Suggested Books
- “Mortgage Management for Dummies” by Diana Donnelly
- “The Loan Officer’s Practical Guide to Residential Finance” by Jeffrey L Bates
- “The Intelligent Asset Allocator” by William Bernstein (Chapters on mortgage-backed securities provide context.)
