Choosing the right type of mortgage is a key decision when buying a home, and for many borrowers, the choice between a variable-rate mortgage and an adjustable rate mortgage (ARM) can be confusing. While both are tied to interest rate fluctuations, they work differently in terms of payment structure and financial impact.
In this blog, we’ll break down the differences between variable-rate and adjustable-rate mortgages, explain how each works, and help you decide which option might be right for you.
What Is a Variable-Rate Mortgage?
A variable-rate mortgage has an interest rate that changes with fluctuations in the lender’s prime rate. However, the unique feature of this mortgage is that the monthly payments remain fixed.
How Does It Work?
When the prime rate changes:
- If rates go down: More of your fixed payment goes toward paying off the principal, and less toward interest.
- If rates go up: A larger portion of your fixed payment is applied to interest, and less goes toward the principal.
In some cases, if rates rise significantly, your payments may need to be adjusted to ensure you’re covering the interest owed (this is called a trigger point).
Advantages of a Variable-Rate Mortgage
- Predictable Monthly Payments: Fixed payments make budgeting easier.
- Potential for Savings: When rates decrease, you can pay off your mortgage faster since more of your payment goes toward the principal.
Considerations
- Changes in interest rates impact how much of your payment goes to the principal, potentially delaying how quickly you build equity if rates rise.
What Is an Adjustable-Rate Mortgage (ARM)?
An adjustable-rate mortgage (ARM) also fluctuates with the lender’s prime rate, but unlike a variable-rate mortgage, the monthly payments change whenever the prime rate adjusts.
How Does It Work?
When the prime rate changes:
- If rates go down: Your monthly payments decrease, potentially saving you money in the short term.
- If rates go up: Your monthly payments increase, potentially making budgeting more challenging.
Advantages of an ARM
- Immediate Rate Benefits: If rates drop, you immediately benefit from lower payments.
- Flexibility: ARMs can be ideal for borrowers who want to take advantage of low initial rates and plan to refinance or sell before rates rise.
Considerations
- Payment fluctuations can make budgeting difficult.
- Rising rates can lead to significantly higher monthly payments, which might strain your finances.
Key Differences Between Variable-Rate and Adjustable-Rate Mortgages
| Feature | Variable-Rate Mortgage | Adjustable-Rate Mortgage (ARM) |
|---|---|---|
| Interest Rate | Changes with prime rate | Changes with prime rate |
| Monthly Payments | Fixed, regardless of rate changes | Fluctuate with rate changes |
| Impact of Rate Increase | Less of your payment goes to the principal | Monthly payments increase |
| Impact of Rate Decrease | More of your payment goes to the principal | Monthly payments decrease |
| Predictability | Predictable payments | Payments vary, less predictable |
Which Option Is Right for You?
Choosing between a variable-rate mortgage and an ARM depends on your financial goals, risk tolerance, and lifestyle.
Choose a Variable-Rate Mortgage If:
- You value stable, predictable monthly payments.
- You’re comfortable managing the long-term impact of rate changes on your principal repayment.
- You want to benefit from rate decreases without worrying about fluctuating payments.
Choose an Adjustable-Rate Mortgage (ARM) If:
- You’re comfortable with fluctuating payments and can adapt your budget as needed.
- You’re looking to take advantage of immediate rate changes, especially if rates are trending downward.
- You plan to sell or refinance before significant rate increases occur.
FAQs About Variable and Adjustable-Rate Mortgages
Can I switch between a variable and an ARM during my mortgage term?
Typically, this isn’t possible because a lender will only offer either a variable or an ARM-style product. It’s best to discuss this with your mortgage broker before committing to a product.
What happens if interest rates rise significantly?
With a variable-rate mortgage, your payment amount remains fixed, but less of it goes toward the principal. With an ARM, your payments will increase to accommodate the higher interest.
Are these mortgages better than fixed-rate mortgages?
It depends on your financial situation and goals. Variable and adjustable-rate mortgages often have lower initial rates compared to fixed-rate mortgages, but they come with more risk due to potential rate changes.
Let’s Find the Best Mortgage Option for You
Understanding the difference between a variable-rate mortgage and an ARM is key to making an informed decision. Whether you’re drawn to the stability of fixed payments or the flexibility of fluctuating payments, I’m here to help you navigate your options and find the right solution for your needs.