Variable Rate Mortgages — When Are They a Good Idea?

By Michelle Rama-Poccia REALTOR® | Real Estate Salesperson | Coldwell Banker Residential Brokerage

Of Mortgages and Homeownership…

Years ago, I was living in a garden condo with my daughter who at the time was in kindergarten. One day, she told me she was wishing for a one-family home with a fenced backyard and a swing. As a single mom making not a whole lot as a journalist at the time, money was tight, so it didn’t seem likely that wish would ever come true.

Still, I decided to look into what it would actually cost to buy a small single-family house — maybe somehow we could swing it with interest rates so low. And rising home prices meant my condo was worth quite a bit more than I had paid for it, so it was a good time to “trade up.” That’s because as prices rose, so did my equity in the condo — which meant more money to put down on a larger home.

That, and the fact there were still some pretty affordable homes in my area, made trading up to a single-family home a real possibility. But to ensure I’d be able to afford the monthly payment, I needed to find the lowest-possible interest rate mortgage. Luckily, I had very good credit, which meant I’d qualify for a lower rate.

For those who might not know what a mortgage is, it’s a loan you take out in order to buy a home if you don’t have the money to pay for it in cash.

Usually, you need to have at least 3% of the value of the home you’re buying for what’s known as a down payment, or your contribution toward buying the home. The rest of the money is supplied by the lender, which charges you an interest rate for lending you the money.

Fixed Interest Rates vs. Variable Interest Rates

Even though I had bought two homes before, I wasn’t really clear on what kinds of mortgage options were available. My understanding was that a fixed-rate mortgage was the most conservative choice because the interest rate wouldn’t change over the life of the loan, so that’s the one I chose. That meant there would be no unpleasant surprises if the government were to raise interest rates suddenly.

Among the fixed-rate loans, the most prudent option seemed to be 30-year, which would give me 30 years to repay the loan with no pre-payment penalty. Since the interest rate would never change, I’d know exactly how much I’d be paying every month for the next 30 years.

Although I would’ve preferred a 15-year fixed-rate mortgage to pay off the loan faster, that would’ve meant a much higher monthly payment. However, I could always shorten the length of my loan by sending an extra principal payment whenever I could afford to.

Upgrading from a condo to a single family home was going to be costly, and I really needed to spend as little as possible on the monthly interest payment, so my mortgage broker at the time suggested I consider an ARM, or Adjustable Rate Mortgage.

I wasn’t really clear on how an ARM worked at the time, and the broker I was working with didn’t explain some of the details in a way I could understand, so I avoided it. It turned out that those types of mortgages would cause problems for borrowers when they “reset” higher after 3 or 5 years — in fact — that was one factor that led to the subprime mortgage crisis in 2008.

Let’s break it down, so you can make an informed choice, and I suggest you also find a reputable mortgage broker who can walk you through which mortgage might work best for you.

Mortgages fall under two categories: fixed rate and variable rate.

Fixed interest rate refers to an interest rate that will not change over time.

Variable rate is an interest rate that changes depending on how much benchmark rates rise or fall in the open market.

A loan with a variable, or adjustable, rate recalculates the interest charged periodically based on a benchmark rate, either LIBOR (which won’t be around much longer), or a U.S. Treasury Bill.

For instance, you may take an adjustable rate mortgage (ARM) that has a low introductory rate of 2%. Then, about three to five years into the loan, the rate will change, or “adjust” to the original low 2% plus a benchmark rate like the one-year Treasury bill. That means you add the 2% or some other pre-determined spread to whatever the T-bill rate is, and that’s the interest rate you’ll pay on your loan for one year. The following year, it adjusts again depending on what T-bill rates are then, and so on until the loan matures.

It changes periodically depending on the prevailing interest rates, and there is no way to predict with certainty what those rates will be over the years, so these can be risky.

Borrowers like the low introductory interest rate of an ARM, which makes the mortgage payment more affordable for several years. The loan is designed to attract borrowers who may not otherwise be able to afford a fixed-rate mortgage at first and may be hoping interest rates will remain low once the interest rate begins to adjust to market value.

When that happens, the mortgage rate can jump higher suddenly depending on how much interest rates have increased since you first took out the loan.

When Is an ARM a Good Idea?

Home buyers who plan to sell their homes within the next few years can reduce their borrowing costs and monthly payments with an adjustable rate mortgages because fixed-rate loans tend to have a higher interest rate compared with the ARM’s beginning rate. Taking advantage of the lower introductory rate, buyers who know they plan to move in three to five years aren’t worried that the rate will reset much higher because they won’t have the mortgage long enough to pay the higher rates.

Had I known back when I was in the garden condo that home prices would keep rising and mortgage rates would keep falling, causing me to trade up a few more times over the years, then I probably would have opted for the variable rate mortgage, or ARM, because I would have sold those houses before the mortgage rates reset higher.

Either way, I was able to find an affordable home that suited my budget and needs with a mortgage I’d feel comfortable paying for many years, and my daughter got her backyard and swingset, so it was a win-win. ❤

Do the Math

Whichever mortgage you choose, don’t rely on the mortgage broker to tell you how much you can afford. The formula lenders use to determine how much money you’re eligible to borrow doesn’t automatically equal that the loan is affordable for you and that you’d be able to comfortably repay that sum. Depending on your lifestyle and spending habits, you may find it difficult to pay a $3,000-a-month mortgage even if you earn a six-figure salary.

As my mother says, get out your pencil and paper and do the math. Add up your monthly expenses and how much you actually spend. Decide which of these expenses, vacations and luxuries you’re willing or able to forego in order to be a homeowner and truly afford the monthly mortgage for which you’ve been approved.