Consumer Mortgage

A variable rate mortgage or floating rate mortgage is a mortgage loan where the interest rate varies to reflect market conditions.

The interest rate will normally vary with changes to the base rate of the central bank and reflects changing costs on the credit markets. This method of variation directly linked to underlying costs benefits lenders and ensures a profit by passing the interest rate risk to the borrower. The borrower benefits from reduced margins to the underlying cost of borrowing compared to fixed or capped rate mortgages. The lender must hedge against potential interest rate changes; the borrower benefits if the interest rate falls and loses out if interest rates rise.

The loan may be offered at the lender's standard variable rate/base rate. There may be a direct and legally defined link to the underlying index but where the lender offers no specific link to the underlying market of index they can choose to increase or decrease at their discretion.

In many countries variable rate mortgages are the standard method of lending and are simply referred to as mortgages. In the US they are referred to as adjustable rate mortgages.

The underlying index varies among countries. In the United Kingdom, it is typically the Bank of England Repo rate or LIBOR. In other Western European countries, the index may be the TIBOR or Euro Interbank Offered Rate (EURIBOR).

In some countries, banks may publish a prime lending rate, which is used as the index. The index may be applied in one of three ways: directly, on a rate-plus-margin basis, or on the basis of index movement.

A directly applied index means that the interest rate changes exactly with the index. In other words, the interest rate on the note exactly equals the index. Of the above indices, only the contract rate index is applied directly.

To apply an index on a rate-plus-margin basis means that the interest rate will equal the underlying index plus a margin. The margin is specified in the note and remains fixed over the life of the loan. For example, a mortgage interest rate may be specified in the note as being LIBOR plus 2%, 2% being the margin and LIBOR being the index.

The final way to apply an index is on a movement basis. In this scheme, the mortgage is originated at an agreed-upon rate, then adjusted according to the movement of the index. Unlike direct or index-plus-margin mortgages, the initial rate is not explicitly tied to any index; the adjustments are tied to an index.

Capped rates

Any mortgage where payments made by the borrower may increase over time brings with it the risk of financial hardship to the borrower. To limit this risk, some lenders may offer a rate cap to limit the maximum interest rate chargeable or other limitations to the frequency of rate changes or magnitude of changes in a given period. Sometimes, rate caps are required by law.

Some markets will apply these changes on the premise that part of the interest-rate risk is assumed by the lender, who is generally well-informed; alternatively, the lender may allow negative amortization/capitalization of the interest not met through repayments.

Popularity

Variable-rate mortgages are the most common form of loan for house purchase in the United Kingdom and Canada but are unpopular in some other countries. Variable-rate mortgages are very common in Australia and New Zealand. In some countries, true fixed-rate mortgages are not available except for shorter-term loans; in Canada and the United Kingdom, the longest term for which a mortgage rate can be fixed is typically no more than ten years, while mortgage maturities are commonly 25 years.

In many countries, it is not feasible for banks to borrow at fixed rates for very long terms. In these cases, the only feasible type of mortgage for banks to offer may be adjustable-rate mortgages (barring some form of government intervention).

For those who plan to move within a relatively short period of time (three to seven years), they are attractive because they often include a lower, fixed rate of interest for the first three, five, or seven years of the loan, after which the interest rate fluctuates.

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