Adjustable rate mortgages

Adjustable rate mortgages (ARMs) are home loans with a rate that varies. As interest rates generally rise and fall, adjustable rate mortgage rates follow. These can be useful loans for entering a home, but they are also risky. This page covers the basics of adjustable rate mortgages.

The rate

Adjustable rate mortgages are unique in that the interest rate on the mortgage adjusts to market interest rates.

This is important because the mortgage payment amounts are determined (in part) by the interest rate on the loan. As the interest rate increases, the monthly payment increases. Likewise, payments fall as interest rates fall.

The rate on your adjustable rate mortgage is determined by some market index. Many adjustable rate mortgages are linked to the LIBOR rate, preferential rate, fund cost index or other index. The index your mortgage uses is technical, but it can affect how your payments change. Ask your lender why they offered an adjustable rate mortgage based on a given index.

Adjustable rate mortgage benefits

A main reason for considering adjustable rate mortgages is that you may end up with a lower monthly payment. The bank (usually) rewards you with a lower initial rate because you are taking the risk that interest rates may increase in the future. Contrast the situation with a fixed rate mortgage, where the bank takes that risk.

Consider what happens if rates go up: The bank is stuck lending money at a rate below the market when you have a fixed rate mortgage. On the other hand, if rates drop, you will simply refinance and get a better rate.

Adjustable rate mortgage pitfalls

Alas, there is no free lunch. Although you may benefit from a lower payment, you still have the risk that fees will increase on you.

If that happens, your monthly payment can increase dramatically. What was once an affordable payment can become a serious burden when you have an adjustable rate mortgage. The payment can get so high that you have to pay the debt.

Managing adjustable rate mortgages

To manage the risks, you want to choose the right type of adjustable rate mortgage. The best way to manage your risk is to have a loan with restrictions and “caps”. Caps are limits on how much an adjustable rate mortgage can actually fit.

You may have limits on the interest rate applied to your loan, or you may have a limit on the dollar amount of your monthly payment. Finally, your loan may include a guaranteed number of years that must pass before the rate begins to adjust – the first five years, for example. These restrictions eliminate some of the risk of adjustable rate mortgages, but they can also create some problems.

You are now up to date on how ARM mortgages work. Let’s see how they sometimes don’t work for you. Note that the term ARM Mortgage is redundant – the M is for mortgage – but use this term throughout the page for familiarity.

Mortgage rebates from ARM can work in several ways. There are periodic caps and life caps. A periodic cap limits how much your rate can change during a given period – such as a one-year period.

Life limits limit how much your ARM mortgage rate can change over the life of the loan.

Examples of ARM mortgages

Assume that you have a periodic limit of 1% per year. If rates increase by 3% during that year, your ARM mortgage rate will increase by only 1% due to the ceiling. Life limits are similar. If you have a life limit of 5%, the interest rate on your loan will not adjust by more than 5%.

Keep in mind that interest rate changes in excess of a periodic limit can be carried forward from year to year. Consider the example above, where interest rates have increased by 3%, but your ARM mortgage limit has kept your loan rate up by 1%. If interest rates are flat next year, it is possible that your ARM mortgage rate will increase 1% more anyway – because you still “owe” after the previous limit.

There are a variety of flavors available ARM mortgages. For example, you can find the following:

  • 10/1 ARM Mortgage – the rate is fixed for 10 years, then adjusts every year (up to the limit, if any)
  • 7/1 ARM Mortgage – the rate is fixed for 7 years, then adjusts every year (up to the limit, if any)
  • 1 Year ARM Mortgage – the Rate is fixed for one year and then adjusts annually to any limit.

The initial interest rate is usually fixed for a certain time, after which it is periodically reviewed (usually every month). The interest rate that the borrower will pay is based on a benchmark to which the spread is added, called the floating interest rate margin.

A floating rate mortgage is also sometimes referred to as a “variable-rate mortgage” or “floating-rate mortgage”

by Abdullah Sam
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