Getting a competitive interest rate is one of the best things you can do when you buy a home. You’ll be paying on the loan for years, which means even one percentage point could save you significant money. But you may find that a lower-rate mortgage is actually a variable rate, which could result in a higher total cost in the long-term than a fixed rate would.
What Are Variable Rate Mortgages?
Also known as an adjustable-rate loan, a variable rate loan varies with the market interest rates. You’ll find your own mortgage’s interest rate changes as interest rates fluctuate. Initially, lenders will typically offer an adjustable-rate mortgage that’s lower than what you’d pay for a fixed rate, which can make it seem attractive at the outset.
There are four components to an adjustable-rate mortgage:
- Index: The index is an indicator that changes as the interest rate rises and falls. Mortgage lenders decide what index they’ll follow to determine whether it’s time to change the interest rate. Many times the index rate is the London Interbank Offered Rate (LIBOR). The prime rate is also a possibility.
- Margin: Lenders are in it to make at least a slight profit. The margin is the cost to the lender to administer the loan, along with a profit built-in. This may be set unusually low at the start to get a borrower’s business, then increase over time. It will be added to the index rate to determine the interest rate for the period.
- Interest rate lifetime cap structure: A variable interest rate will have a cap to ensure your rate never goes above a certain number during the term of the loan. There will be both a cap on how much it can change with each adjustment and how much it can increase over the life of the loan. This makes it possible for the borrower to know in advance, the maximum portion of the loan payments that will be due to interest.
- Initial interest rate period: During the earliest periods of your loan, your interest will have a cap on it designed to keep your interest low. This cap will only be applied short-term, for a limited time.
What Are Fixed-Rate Mortgages
In most cases, the mortgages being offered are fixed-rate loans. A fixed-rate loan doesn’t change once it’s locked in. You will typically lock in a rate before closing and that rate will remain over the life of the loan.
With a fixed-rate loan, you can count on the same monthly principal and interest payment for the loan term, unless you refinance or pay off the loan. But that doesn’t mean your payment can’t change. Your property taxes and homeowner’s insurance premiums will likely increase over the time you’re in the house, so your payment will probably go up to make sure those are covered in your personal finance planning.
Benefits of Variable Rate Mortgages
Often the biggest benefit of a variable interest rate loan is what draws you to it in the first place. You’ll probably see a lower interest rate with variable rate mortgages than what’s being offered with fixed-rate loans. This introductory rate can be great if your income is expected to increase in the near future, giving you time to get settled into your house before your payment starts to go up. You could also opt to refinance, making repayment of the variable-rate mortgage with the proceeds from an attractive fixed-rate loan for the remainder of the loan balance.
For new homebuyers, variable-rate mortgages can get you into a home when you might otherwise not qualify. Your monthly mortgage payment will be lower, at least initially, so your debt-to-income ratio can be a little higher than what it would need to be to qualify for a fixed-rate mortgage.
But borrowers of means can also benefit from a variable rate. Having a lower monthly payment means you can supplement it with lump-sum payments throughout the year, giving you more flexibility than you’d have if your monthly rate was higher.
Read more: What Are Some Risks of a Variable Rate Loan?
Benefits of Fixed-Rate Mortgages
Having a fixed interest rate comes with some benefits, too. Mainly, if the interest rates increase at any point after you lock in your rate, it won’t affect your monthly payment. This can be especially useful if you plan to stay in the home for a decade or longer.
Another benefit of a fixed-rate mortgage is that your payment agreement is relatively straightforward. Your payment will remain the same every month, aside from periodic adjustments due to increases in property taxes and homeowner’s insurance premiums. If interest rates are low, a fixed-rate loan may also be just as easy to qualify for as an adjustable-rate mortgage.
Refinancing a Variable Rate Mortgage
Signing a variable rate mortgage doesn’t mean you’re stuck with it for life. You may plan to sell the home in a few years anyway, allowing you to trade it in for a home that has a fixed-rate mortgage. But even if you intend to stay in the home a while, there’s always the option to refinance the mortgage into one with a fixed rate.
For best results, wait to refinance your mortgage until interest rates are low and your credit score is fairly solid. It also can’t hurt until your debt-to-income ratio is at its lowest. Keep in mind, though, that you’ll face refinance closing costs of 3 to 6 percent, which is at least $9,000 on a $300,000 loan.
Read More: Refinancing Vs. Extra Payments
Unraveling Variable Rate Mortgage Terms
The biggest downside to an adjustable-rate mortgage is that the terms can be complicated. It’s important to read the fine print to make sure you understand how high your rate can go before it will cap. Variable-rate mortgages can also sometimes come with a prepayment penalty, which means if you refinance or pay it off, you’ll be charged a penalty.
The biggest thing to be aware of before agreeing to a variable rate mortgage, though, is the interest rate environment. If interest rates are likely to decline after you move into the house, you could actually save money. But if interest rates are unusually low, you could see your interest rate increase all the way up to the rate cap during your time in the home.
Low-Credit Borrowers and Mortgages
One reason to be wary of variable-rate mortgages is that they’re typically marketed to borrowers who have difficulty qualifying. Those with lower credit scores and high debt-to-income ratios can qualify for the lower initial monthly payments that you get with a variable rate mortgage.
But low credit borrowers are also a higher risk for a lender. When a lender takes on a higher risk, typically a higher interest rate is applied to make up for it. That means in addition to unpredictable rates, they may start on the higher end anyway for the interest rate on their loan amount.
Alternatives to Variable Rate Loans
If you’re looking at a variable rate loan as a way to qualify, a fixed-rate loan that’s government-backed could be an option. Conventional loans typically require a credit score of 620 or above, but you can get in with a score in the upper 500s with an FHA loan. FHA loans also have lower down payment requirements, which can help you if you’re strapped for cash.
Even with a conventional loan, though, approval depends on a variety of factors. Lenders will take a look at your income, how much debt you have and whether you have bankruptcies in your past. The more you have for a down payment and the lower-priced the home you’re trying to buy is, the less money the lender will be letting you borrow, thereby reducing its risk.
Read More: What Credit Score Do I Need for a Mortgage?
Whether you choose a fixed-rate loan or one with a variable rate, it’s important to take a look at the terms. Make sure there’s no prepayment penalty in case you want to refinance, and also look at the interest rate caps if you opt for a variable loan. You can make either type of loan work for you as long as you go into it with both eyes open.
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.