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 by ensuring 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 where the lender must hedge against potential interest rate changes where 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 be referred to as mortgages. In the US they are referred to as adjustable rate mortgages.
The underlying index varies in different countries.
In Western Europe, the index may be the TIBOR or Euro Interbank Offered Rate (EURIBOR).
Six common indices in the United States are:
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 based on 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 based on 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.
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.
Some markets will apply these changes on the basis that part of the interest rate risk is assumed by the lender, alternatively the lender may allow negative amortization/capitalisation of the interest not met through repayments.
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.
The fact that a variable rate mortgage has a lower starting interest rate does not indicate what the future cost of borrowing will be (when rates change). If rates rise, the cost will be higher; if rates go down, the rate will be lower. In effect, the borrower has agreed to take the interest rate risk. Some studies have shown that on average, the majority of borrowers with variable rate mortgages save money in the long term; but they have also demonstrated that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the risk of potentially higher costs.