Pros & Cons of Adjustable Rate Mortgage

What is an Adjustable Rate Mortgage?

An ARM or Adjustable Rate Mortgage means that the interest rate of your mortgage loan fluctuates; the interest rate can go up or go down, depending upon the market condition.

The ARM is made up of two parts.  The first is the INDEX or that part of the interest rate that is forever changing as affected by inflation and different market factors and is not constant.  It is also referred to as the benchmark interest rate. The other is the MARGIN (or a ‘spread’) which is the amount that a lender charges and is constant all throughout the term of the loan. Combining the two, index and margin, make up the fully indexed rate of an adjustable rate mortgage.

The lender has no control over the rise and fall of the mortgage index. They only use these indexes to determine the rates of an adjustable rate mortgage.  Some common and more popular indexes used are the 11th District Cost of Funds Index (COFI), Moving Treasury Average (MTA) or Monthly Average Treasury (MAT), London Interbank Offered Rate (LIBOR), Constant Maturity Treasury (CMT) among others. LIBOR is the most commonly used index of an ARM.

An adjustable rate mortgage is a mortgage type that can start with a low-interest rate at the beginning, called the “initial rate period,” but can ‘adjust’ to increase or decrease depending on the movement of the Index in the market.  A ‘fully indexed’ loan increases or decreases depending on the fluctuations in the index, but the margin does not change. Now, if the initial loan is lower than the fully indexed rate, then you have a ‘discounted index rate’ or a “teaser.”

fixed vs adjustable rate mortgage

Interest Rate Caps

An interest rate cap puts a limit on the amount that the interest rate can increase. The interest rate cap comes in two forms:

  • Periodic – a periodic adjustment cap limits the amount in which the interest rate can adjust up or down from one adjustment period to the next after the initial or first adjustment.
  • Lifetime – a lifetime cap limits the interest rate increase over the life of the loan. The law requires all adjustable rate mortgages to have a lifetime cap.

In addition to the interest rate caps, most adjustable rate mortgages also have a cap on the amount your monthly payment may increase at the time of each adjustment, even if the interest rate rise more. In the event this happens, the difference between the change and the payment cap will be added to the balance of the loan, and this leads to negative amortization.

Most adjustable rate mortgages that have payment caps do not have a periodic interest rate cap. Besides, most payment option ARMs have a built-in “recast” or recalculation period. Generally, this is every five years, sometimes seven years. At that point, the monthly payment is recalculated based on the remaining term of the loan. So, if you have a 30-year term, but already at the end of year five, the monthly payment is recalculated for the remaining 25 years. The payment cap does not apply to this adjustment anymore. If the loan balance has increased, or if the interest rate has risen faster than the payment itself, the monthly payment can go up tremendously. So, if a borrower gets a 5/1 ARM, it means that the loan is fixed for the first 5 years. After that, the rate will adjust every year for the rest of the term of the loan.

Now we have a basic understanding of what is an Adjustable Rate Mortgage.  The question now is, “how can it benefit the borrower?” and “are there downsides to it?”

A borrower used to be able to afford to buy a more expensive house than they normally would using an adjustable rate mortgage. In today’s market, a lender will use and calculate eligibility of the borrower based on the payment with future adjustments to qualify the borrower who insists on getting an adjustable rate mortgage.

ARMs can be beneficial for the borrower especially at the start of the mortgage term because usually, the interest rate starts low within the first couple of years of the term or before the first adjustment. It might have offered a teaser rate at the start.  This means that for example, when you are already a bit ‘dry’ after spending money on buying a home, having a low-interest rate will help the first years of paying a low mortgage monthly payment. It can be a lifesaver. Therefore, it can enable you to continue paying without much financial duress and may have extras to complete buying your furniture, repairs, fix the lawn and other home-related expenses.

For as long as the interests remain low, Adjustable Rate Mortgages can be beneficial for the borrower.  But as anything ‘not fixed,’ the risk is there; after some time, the mortgage indexes may and will increase, thus also increasing the interest rate and overall monthly payment.  The time may come when you will pay more interest than projected. Of course, the increases are not without control; the cap limits the adjustment increase.

For additional information about Adjustable Rate Mortgages, its features and benefits, please your nearest Home Loan Specialist or find them online.