Flexible Rate Mortgage: Definition, Advantages and Disadvantages
Mortgage products that have their interest rate adjusted with the interest rate changes according to set criteria called Flexible Rate Mortgage. These mortgage rates increases if the interest rates go up and decreases when the interest rates go down. Some product rates may be adjusted monthly, some yearly. In some counties, they are very popular (or banks mainly offer these products). They are called Adjustable Rate Mortgage as well.
In most cases, these loans have a low interest start and increases to banks normal lending rates which is mostly calculated as the base rates + a percentage charge. For example, if the bank base rate (or central bank base rate) is 1% and the lender charges 2%, the rate charged would be (1 + 2 =) 3%. When the base rate goes up to 2%, the mortgage interest rate charged to borrower would go up to 4%. Although banks may use different rates as their base rate (LIBOR, Central Bank Base Lending Rate, etc), the calculations are similar and set on the mortgage terms.
These products may be popular at times of high interest rate periods with an expectancy of rate cuts. Since they follow the rate changes, they do not tie the borrower down with a fixed rate. These types of mortgage products are used quite well by banks. They may offer very low initial interest rates to draw and qualify as many customers as possible, knowing that they will be able to charge the rate they intend in a year or so. Adjustable rate mortgages normally have lower interest rates than the fixed rate mortgages. As they have a cheaper interest rate (lower monthly payments) to start with more people would qualify for these mortgages and they would be able to borrow more than a fixed rate deal allows. Maximum mortgage amount offered to an applicant is in most cases calculated based on what the applicant can afford with his/her income. That is why adjustable rate mortgage would allow an applicant to qualify higher mortgage amount.
The problem with flexible rate mortgage is that applicants may be short sighted with their low interest rates and monthly payments. They may not pay much attention to where the rates might end up. Or they may be optimistic about their future earning potential. Some people somehow manage to see only the positive side of things. They would be laughing if the rates keep going down, but they may not be able to afford mortgage payments even the rate changes slightly.
The other problem is that the mortgage lenders may manipulate these rates. They may offer ridiculously low starting rates for a short period of time. Lenders do these promotional discounts to get more customers in their book and qualify even more customer. As the loan applicants qualify for larger mortgages, this makes it even more difficult for them to pay the increased monthly payments when the rates go up.
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