A variable-rate mortgage is a mortgage where the interest changes as the market conditions changes. Unlike a fixed-rate mortgage where consumers pay a constant rate, a variable rate mortgage consists of varying monthly payments. Mortgage lenders usually follow a financial index like the federal lending rate. If the specific index changes, the mortgage lender will amend its rates to match the changes. However, changes to the interest rate are not drastic but moderately happen sporadically according to the mortgage agreement.
The variable rate mortgage is attached to a specific benchmark index which acts as a reference rate. Such reference rates are the interest rate at which banks borrow from each other. The rate is realized by gauging banks and obtaining statistics on the interest rates charged after borrowing from their colleagues. The prime rate in the country can also be used as a reference for mortgages, credit cards, and auto loans. The rate is subject to the Federal Reserve funds rate, which refers to the interest rate charged for overnight loans to adhere to reserve funding requirements.
A variable rate mortgage is beneficial to consumers because they attract a lower interest rate than a fixed-rate mortgage. Initially, the interests are low, but they are subject to change later in the loan term. However, in high rising interest rates, a fixed-rate mortgage will make more sense to borrowers. Borrowers prefer variable mortgages when they expect a fall in interest in the future. If the loan agreement contains a cap on variable rates, consumers will be protected from too much interest. A ‘cap’ limits the maximum amount that a borrower can be charged irrespective of the reference interest rate. A variable rate mortgage will be of more excellent value than a fixed-rate mortgage from the lender’s point of view. Lenders can adjust interest rates upwards to cope with economic conditions, but a fixed-rate mortgage maintains the interest rate no matter the status of the market changes.
Types of variable rate
The three main types of variable mortgages include:
- Standard variable rate mortgage (SVR)
Standard variable rate refers to the mortgage rate that your lender will transfer you to after the expiry of the introductory deal. Every lender has their SVR, which is the default interest rate if you don’t remortgage. Mostly, the standard variable rates are higher than other types of mortgages. Generally, part of your mortgage repayment goes towards the principal amount and the other part towards the interest rate charged by your lender. If your mortgage lender increases their SVR, your monthly payment will increase too, but the extra amount you pay will go towards the higher interest instead of the principal amount. A lender can either increase or decrease its SVR at any time and by any amount. A borrower has no control over these changes.
- Discounted rate Mortgage
A discount mortgage provides a discount on the interest rate at a certain level below your lender’s SVR for a set duration. As the SVR goes up and down, the discount mortgage will reflect the variations and also move up and down. Typically, discount mortgages are provided for a specified period after which your mortgage lender transfers you to its standard variable rate. Its advantages are that you will enjoy a lower rate for the discounted period than those in the SVR, and if your mortgage lender’s SVR falls further, you could save more.
- Tracker rate mortgage
A tracker mortgage is a mortgage loan whose interest rate is based on an external rate. If the base rate increases, then the rate on your tracker increases too. In some cases, a fall in the base rate will reduce your tracker interest rate. However, the tracker mortgage often has the minimum limit you can pay at the beginning of the deal.
Since a tracker rate mortgage is a variable mortgage, the amount you pay monthly is subject to change over time. If your monthly payment increases due to a rise in the base rate, the extra money you will pay will only cover the higher interest charges and not the principal amount.
A tracker mortgage is usually tied on the base rate for a set period, after which the borrower is reverted to the lender’s standard variable rate. Obliging to a longer tracker deal is risky because it’s difficult to predict future rates. The longer your tracker mortgage deal, the higher risk it might attract.
In conclusion, it is advisable to consider your financial status and evaluate all types of variable mortgages, before striking a variable mortgage deal when buying a home.