What is a Variable-Rate Mortgage (VRM)?
A Variable-Rate Mortgage (VRM) is a long-term residential loan where the interest rate can be adjusted periodically, typically every six months, based on changes in a specified financial index. Unlike fixed-rate mortgages, the interest rate on a VRM is not static and changes with market conditions.
How VRMs Work
Rate Adjustment Period: The interest rate on a VRM is reviewed and potentially adjusted every six months, depending on the index used for the agreement.
Caps on Rate Increases: There are limits to how much the interest rate can increase. Generally, the rate cannot increase by more than ½% per year or 2½% over the life of the loan, providing some level of predictability and protection against drastic changes.
Example Scenario:
Let’s consider Abel, who secures a VRM with an initial interest rate of 6%. After six months, if the relevant index increases by one percentage point, Abel’s interest rate adjusts to 6½%. Due to the annual cap of ½%, this rate will remain for the rest of the year regardless of further changes to the index.
Comparison with Adjustable-Rate Mortgages (ARMs)
The term ‘Adjustable-Rate Mortgage (ARM)’ is nowadays more commonly used to describe loans similar to VRMs. While the core mechanics remain the same, ARMs can have different adjustment periods, lifetime caps, and rules depending on the lender’s terms.
Benefits of a VRM
- Potential for Lower Initial Rates: Often, VRMs start with lower rates compared to fixed-rate mortgages.
- Flexibility: Monthly payments can vary, reflecting the current interest environment.
- Short-Term Advantage: Ideal for homebuyers who plan to sell or refinance before the rate adjustment period concludes.
Risks of a VRM
- Unpredictable Payments: Monthly payments can increase significantly if the market interest rates rise.
- Budgeting Challenges: The variable nature makes it harder to predict long-term financial outlays.
Frequently Asked Questions
Q: What makes VRMs different from Fixed-Rate Mortgages?
A: The main difference lies in the interest rate. VRMs have adjustable rates that change with the financial index, while Fixed-Rate Mortgages have constant interest rates over the term of the loan.
Q: Are there any protections for borrowers against rapid interest rate changes?
A: Yes! VRMs typically come with interest rate caps that limit how much the rate can increase annually and over the life of the loan.
Q: What are some common indices used for VRMs?
A: Common indices include the LIBOR (London Interbank Offered Rate), the 11th District Cost of Funds Index (COFI), and the U.S. Treasury Securities rate.
Q: When is choosing a VRM suitable?
A: A VRM can be suitable for buyers who expect stable or decreasing interest rates in the future or those who plan to sell or refinance within a few years.
Q: Can I switch from a VRM to a Fixed-Rate Mortgage?
A: Yes, many borrowers choose to refinance to a fixed-rate mortgage if they anticipate rising interest rates or prefer more predictable payment structures.
Related Terms: Fixed-Rate Mortgage, Mortgage Refinancing, Interest Rate Cap, Index Rate, Mortgage Loan Term.
