The Pricing of Variable Rate Mortgages

This paper analyzes the potential pricing of the type of variable rate mortgage (VRM) proposed by the Federal Home Loan Bank Board in February, 1975, but the analysis is applicable to many types of plans. Equations are developed and simulations reported showing that the initial interest rate for VRM's will be at or below the rate on FRM's (for the two to be of equal yield), where refinancing is considered likely. But where refinancing is not likely, then the initial rate for VRM's will be higher than the FRM rate (for the two to be equal yield), but only when the VRM index is expected to fall. Recent VRM experience in California is also discussed.