Variable interest rates: Should you get one?

A mortgage rate is the amount you pay annually to borrow money on a home. It's important to fully grasp the ins and outs on how mortgage interest rates work. It can help you gain a greater understanding of the total costs of your home loan – and what factors can impact your rates. As a result, it can help you land on the right mortgage, budget for your housing costs, and make sure it's within the realm of what you can reasonably afford. Let's dig in.

What is a variable interest rate?

Having a variable interest rate means the rate on your mortgage can go up or down. A variable interest rate is based on an index rate such as the prime rate.

When the rate goes up, your mortgage rate will also go up – and your monthly payment increases. And vice versa. So while your principal remains the same, your interest rate can fluctuate over the life of the loan.

When you're buying a home, you'll likely run across a variable interest rate with an adjustable-rate mortgage (ARM). These home loans usually start with an initial interest rate that's typically lower than a fixed-rate loan. Once the initial rate ends – which can be anywhere from several months to several years – the interest rate will fluctuate on a regular basis.

Variable- vs. fixed-interest rates

Let's take a look at the core differences between variable-interest rates and fixed-interest rates.

While a fixed-interest rate doesn't change throughout the life of the mortgage, a variable-interest rate can. Fixed-rate mortgages are more common among home loan borrowers, and it means you can expect steady, predictable payments – and avoid shock should your payments go up.

Variable-rate mortgages can pose a higher risk for you as a borrower. That's because the longer the length of your loan, the more times the interest rate can go up.

That said, ARMs usually have caps on how much the rates can go up and down in the adjustment periods that follow, and how much the rate can fluctuate in total throughout the duration of the loan.

Types of loans that use variable interest rates

Let's look at loans that offer variable interest rates:

• HELOCs. Home equity lines of credit (HELOCs) usually have variable interest rates, and are tied to the U.S. prime rate. Other factors that can affect your APR on a HELOC include the loan amount, your property's loan-to-value (LTV) ratio, and how creditworthy you are.
• Credit cards. Credit cards typically have variable rates and can change month-to-month. With credit cards, the APR and interest rate are usually one and the same. There are three separate APRs: the purchase APR, balance transfer APR, and cash advance APR.
• Private student loans. Private student loans can have variable or adjustable interest rates. While fixed rates are usually seen as the better choice, variable-interest student loans could be the better route if you can knock out that debt quickly.
• Personal loans. Personal loans can have interest rates that are variable or fixed. It might be worth it to opt for a variable rate on a personal loan in market conditions with a declining interest rate. Or, if you’re opting for a shorter loan term.

How do variable interest rates work?

Let's take a closer look at how variable interest rates work and the mechanisms behind them.

Adjustment periods

An adjustment period is the window of time that an adjustable-rate mortgage (ARM) can be reset. This can be monthly, semi-annually, annually, or every few years.

For example, a 5/1 ARM features an interest rate that's locked in for 5 years, then adjusts each year. A 7/6 ARM has a 7-year fixed interest rate. After that, the rate resets every 6 months.

Caps and floors

Interest rate caps are how much an interest rate can increase throughout the length of the loan. Interest rate floors are how much the rate can decrease throughout the loan's duration.

• An initial adjustment cap is how high or low the interest rate can go the first time it adjusts.
• Subsequent adjustment caps are how much the rate can fluctuate in the following adjustment periods.
• Lifetime adjustment caps are how much the interest on a loan can rise or fall throughout the entire life of the loan.

Benchmark indexes used for variable interest rates

A benchmark index is a market index or reference rate that's used to track a segment of the market or specific stock market. A mortgage index rate is a benchmark index rate that lenders use to determine rates for ARMs.

LIBOR index

Short for London Interbank Offered Rate, LIBOR is based on the average interest rate for major banks to borrow money from each other on a short-term basis.

The U.S.-dollar LIBOR was commonly used to set the interest rates for financial products like ARMs and floating-rate loans. However, the main LIBOR panel halted in June 2023, and its synthetic versions fully discontinued in fall of 2024. It was phased out entirely due to concerns that some banks were manipulating the benchmark.

Secured Overnight Financing Rate (SOFR)

The Secured Overnight Financing Rate (SOFR) is a measure of the cost of borrowing overnight collateralized by Treasury Securities in the repurchase market.

The SOFR represents the near risk-free rate and measures the cost to a bank for borrowing money overnight. In other words, it reveals how much interest a lender will have to pay the next day. The SOFR is used for mortgages, bonds, corporate loans, and derivatives.

Prime rate

The prime rate is the interest rate that's used as a benchmark for ARMs, personal loans, credit cards, HELOCs, and small business loans. It follows closely the federal funds target rate.

This is set by the Federal Reserve – the Federal Open Market Committee, in particular. ARMs can be linked to the prime rate. So if the prime rate rises, so does your interest rate – along with your monthly mortgage payments.

Federal Cost of Funds Index (COFI)

The Federal Cost of Funds Index (COFI) is a benchmark for some securities and mortgage types. The COFI was introduced in 1981 and is used for ARMs. 

Pros and cons of variable interest rates

Mortgages with variable interest rates aren't for everyone. There are potential advantages and downsides to them. Before you decide whether an adjustable-rate mortgage is a good fit for you, you'll want to get know what you're getting into:

Pros

• Lower initial rate: ARMs usually have a lower initial interest rate – 0.5% to 0.75% lower than their fixed-rate counterparts. In turn, it could save you a substantial amount of money during the first leg of your mortgage.
• Rate caps: While ARMs can have fluctuating interest rates, there are rate caps on how much the rate can go up in the initial increase, subsequent increases, and for the life of the loan.
• Rates can drop: It's a good idea to anticipate your interest rate to rise, but interest rates on an ARM can also go down. It depends on monetary policy and benchmark interest rates like the SOFR.
• Can help you save if you plan on selling: If you plan on selling or refinancing your home in a few years, an ARM could be a good idea. You'll need to be prepared in case you don't sell when you'd like, and need it to wait it out.

Cons

• Interest rates can rise: Because ARMs can have fluctuating interest rates, you can expect the rate to go up.
• Increase in monthly payments: If the interest rate goes up, you'll need to make higher monthly payments, and pay more in interest during the life of the loan.
• Risky if things don't go as planned: Let's say you landed on an ARM with the plan to sell or refinance your home in a few years, but the market is down, or your personal financial situation and plans shift. In that case, you'll be stuck with an ARM that could mean higher interest fees.

Should you get a variable-interest rate mortgage?

A variable-interest rate mortgage could be a good idea if you can take advantage of the lower initial interest rate, know the pros and cons, and are aware of your mortgage's interest rate caps and floors.

Before getting this type of mortgage, you'll want to ask yourself the following questions:

• Is this a starter home or a forever home?
• Do I plan on moving soon?
• What are my long-term financial goals?
• Will I be willing to sell in the near future?
• How high can my interest rate potentially increase each year and over the life of the mortgage?
• What are the initial rate caps, subsequent rate caps, and lifetime rate caps?
• Can I afford the potential interest rate increases?

The bottom line: A variable rate can be a good option for you

A mortgage with a variable interest rate could be a sound choice for you if you can manage the potential rate increases, or you plan on moving, selling, or refinancing your home within a few years. To help you make a decision, you'll want to be well aware of how variable-rate mortgage works and its potential pluses and minuses.

Curious to learn more? Explore Rocket Mortgage’s ARM options today. When you’re ready, reach out to a Home Loan Expert and start your preapproval.

Refinancing may increase finance charges over the life of the loan.

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