Adjustable Rate Mortgages

An adjustable rate mortgage is one where the interest rate charged is linked to an economic index. If the index goes up the interest rate charged on the mortgage interest rate will increase (advantageous to the lender) but if the index goes down then the interest rate charged will go down (advantageous to the borrower).

Each lender uses one economic index to adjust the interest charged. There are several economic indexes used by lenders to set the interest rate with common indexes being one, three and five year Treasury bills and the LIBOR (London Interbank Offered Rate).

As well as the economic index the lender charges a margin. This margin is fixed for the length of the mortgage.

As an example, if the index was 4% and the margin 2% then your interest rate would be 6%. If the index were then to change to 4.5% the margin remains 2% and the new interest rate on your mortgage would be 6.5%.

Adjustable Rate Mortgages have a beginning period during which the initial interest rate will not change, after this period the interest rate will change depending on the index. There is no set time for the beginning period and the time period between adjustments. The longer the fixed rate period the greater the risk to the lender so the larger the initial interest rate charged. Also, the shorter the time between adjustments the less risk to the lender and the lower the margin charged.

To protect the borrower from sudden changes in interest rates a couple of different types of limits are often used:

1. A maximum interest rate that can be charged. This interest rate is expressed as the maximum interest rate that the lender will charge the borrower, e.g. 19%.
2. An interest rate cap that limits the change for an adjustment period. If 5% is the agreed cap then the loans’ interest rate can only change within a 5% range for each adjustment period.

In the case where the index rose 6% and the borrower had a 5% interest rate cap the borrower would only pay an additional 5%. However, a problem occurs as the borrower continues to have mortgage interest charged at market rates but is only paying at the lesser capped rate. In this case the payment will not cover the interest and the difference will be added to the principle, a process known as negative amortization.

Advantages:

• The initial interest rate for an ARM is less than for a fixed rate mortgage. This will lower your initial monthly payments and may help you to qualify for a mortgage.
• If you aren’t going to stay in the house for a long period of time, the lower initial payments may be all that you pay with the adjustment period being set to happen after you move.
• If you expect your income to rise then the increase in earnings will cover any increase in the mortgage due to an increase in the index used.

Disadvantages:

• If the market interest rate increases past the maximum the lender can charge the borrower, the monthly payment will not cover the interest part of the mortgage and the lender adds the difference to the principal. Borrowers could end up with a larger mortgage than they started out with.