When you need to take out a loan to purchase your home, you can elect to use a fixed rate mortgage or a variable mortgage. Knowing how variable rate mortgages work and what options lenders offer can help you make a more informed decision as to whether a variable or fixed rate mortgage is best for you.

Function

Lenders determine interest rate on an adjustable rate mortgage by adding the margin to the interest rate index to which the interest rate is tied. Variable rate mortgages tend to use the London Interbank Offered Rate (LIBOR) or the cost of funds index (COFI). The margin is a percentage added to the interest rate index which varies by mortgage; the lender sets the margin based on the creditworthiness of the borrower. The more creditworthy the borrower, the lower the margin. The margin remains the same for the term of the loan.

Time Frame

Variable rate mortgages tend to have the same overall term as fixed rate mortgages, typically 15 to 30 years. However, within that overall term, variable rate mortgages have several important dates: the introductory period and subsequent adjustment periods. The introductory period can last from one year to five or 10 years. After the introductory period, the interest rate adjusts based on the current market rate every year or two. This adjustment can mean a rate increase if rates have risen or a rate decrease of rates have fallen. For example, a 3/1 variable rate mortgage would have the same rate for three years and then adjust each year after that while a 6/3 variable rate mortgage would have the introductory rate for six years and then adjust every three years thereafter.

Types

Lenders offer a variety of variable rate mortgages. Hybrid variable rate mortgages have a fixed rate for several years and then revert to a variable rate mortgage after the introductory period. Interest-only variable rate mortgages offer the borrower the ability to make interest-only payments for the first few years of the mortgage and then revert to a fully amortizing mortgage. Some variable rate mortgages offer a payment option, which allows borrowers to choose an interest-only payment, a minimum payment that does not cover the interest or an amortization payment, or an amortizing payment, usually the amount needed to pay off the loan over 15 or 30 years. If you elect to pay less than the amount needed to pay off the mortgage, you will have to make a balloon payment at the end of the term of the loan. For example, if you have a 15-year term and you make only the interest payments, you would have to pay the balance in a lump sum at the end of the term or refinance, assuming you qualify.

Features

Many variable rate mortgages offer caps on the amount of change allowed in the interest rate. These caps can apply to the amount the interest rate can change over the life of the mortgage or per adjustment period. For example, a variable rate mortgage with a lifetime cap of 6 percent would not increase more than 6 percent over the term of the mortgage, even if rates increased more than that. A periodic rate adjustment cap limits how much the interest can change each adjustment period. For example, if the variable rate mortgage has a 1.5 percent periodic rate adjustment cap, the interest rate could not increase or decrease more than 1.5 percent each time the rate changes.

Benefits

Variable rate mortgages often offer borrowers a low introductory rate that does not change for a set period of time at the start of the loan. In addition, if interest rates fall, borrowers do not have to spend the time and money to refinance their loans in order to take advantage falling interest rates. However, borrowers should beware that if the rates rise, so will the monthly payment. If a borrower can no longer make the higher payment, he could lose the home.