Adjustable rate mortgage explained

Regardless of the loan you are shopping for, you should always pay attention to all costs associated with it. Namely, you should inform your self about the different fees, as well as the type of interest rate charged by the lender. Understanding these costs could help you in your decision to take a loan that will offer the highest value at the lowest cost. Although fees should not be neglected, you should pay special attention to the interest rate you will be paying on your loan. The interest rate represents the highest cost for you when talking about loans. Moreover, keep in mind that the longer the repayment period of your loan the higher the interest cost for you. Prior to deciding on the type of loan you will take, you must understand the types of interest rates that are offered by the banks. This is especially true for mortgage loans which have longer maturity period. Thus, missing the opportunity to take up a loan with 1% lower interest rate could cost you thousands of dollars in the long run. Having said that, it should be pointed out that variable interest rate is a type of interest rate offered by banks. So, the mortgage bearing a variable interest rate is known as an adjustable rate mortgage (ARM). Understanding the adjustable rate mortgage is crucial before applying for this type of mortgage loan. Don’t forget to check other mortgages available as well.

What is adjustable rate mortgage?

Before trying to understand the adjustable rate mortgage, you should firstly understand the basic idea behind fixed rate mortgage. Namely, fixed rate mortgage is a mortgage where the interest rate charged by the bank (lender) remains the same during the entire loan life. Meaning that, regardless of the changes in the market (or benchmark) interest rates, the fixed rate mortgage bears the same interest rate, it will be the same during the entire repayment period.

Coming to the adjustable rate mortgage, as the name implies, the interest rate is adjustable. Stated differently, when taking out a mortgage with adjustable interest rate, the interest rate itself, is divided in two periods. The first period is when the interest is fixed, while after the expiration of this period, the interest rate is reset (adjusted) periodically. The adjustment is not made randomly, instead, the lender makes the adjustment using a benchmark rate. This benchmark market rate could be for instance LIBOR, COFI or MTA .The adjustment of the interest rate could be increasing or decreasing depending on the movement in benchmark market rate. Defining the ARM in simple terms then – it is a mortgage where the interest rate could increase or decrease during the period of the loan.

Because the adjustable rate mortgage is a mortgage where the interest rate is subject to changed there are couple of things that should be understood. Namely, you should be aware about the different types of caps and they should be defined accordingly. The aim of the different types of caps is to outline and maintain control over the adjustments of interest rates. More precisely these types of caps have the purpose to control how and by how much interest rate and/or monthly payment are adjusted.

Some of the terms that you should be acquainted with when trying to understand ARM mortgage are:

Initial rate – is the rate you will pay when you take out a mortgage. Depending on your type of ARM, this rate can be fixed during a predefined period, afterwards it will be subject to adjustments.

Initial fixed rate period – is the period during which the interest rate on your mortgage is locked (fixed). You are paying the initial rate during this period. After the initial fixed rate period is over, you will pay different interest rate (depending on the benchmark rate).

Adjustment period – is the period after which the interest rate will be subject to changes. For instance

Adjustment index – is used as a benchmark interest rate showing the current market conditions. Thus, the benchmark interest rate changes on the basis of the market conditions. There are different indexes associated with the ARM, thus it is important for you to know the index used for your ARM. The importance of adjustment index is that changes in index amount will induce changes in the interest rate on your ARM.

Adjustment frequency – is showing the frequency at which the interest rate changes will be made. Depending on the type of ARMs, the adjustment frequency will differ.

Interest rate cap – or interest cap structure serves the purpose to protect borrowers from excessive increase in the interest rate on their mortgage. There are couple of common interest rate caps associated with ARM. These are: Initial cap (or initial adjustment cap), subsequent adjustment cap (or periodic cap) and lifetime cap (or lifetime adjustment cap). The aim of interest rate cap is to limit the maximum amount that can be made with each adjustment. In addition, another aim of the caps is to limit the extent to which the interest rate can increase over the course of loan life.

  • Initial cap is limiting the amount by which the interest rate can adjust (increase) during the first interest rate adjustment date. Stated differently, initial cap is showing the maximum amount the interest rate can adjust when the fixed rate period expires.
  • Subsequent adjustement cap is limiting the maximum amount by which interest rate can adjust from one perod to another. This cap is showing the maximum amount by which the interest rate can increase at each subsequent adjustment period. It should be noted that the initial cap and the periodic cap can be same or different.
  • Lifetime cap shows the maximum amount the interest rate can increase during the life of the mortgage. Meaning that the total adjustment over the life of the miortgage can not exceed the lifetime cap.

Payment cap – while interest rate caps are limiting the extent by which the interest rate can adjust, some ARM have payment cap as well. This type of cap is showing the maximum amount your monthly payment can increase during each adjustment. For instance, if the payment cap on your loan is 6%, your monthly payment can not increase by more than 6% compared to your previous payment. This is even in situation when interest rates rise more. Imagine that your monthly payment for the previous period was $1,000, and the payment cap is 6%. The maximum amount your monthly payment could increase in the next period is $60, or up to $1,060. There is negative side of ARM in case of bigger rise in interest rate though. Namely, the interest you will not pay because of the payment cap, is going to be added to the balance of your loan. This is called negative amortization.

Types of adjustable rate mortgages

There are different adjustable rate mortgages. They could differ from each other in terms of their repayment period, adjustment frequency, etc. Some of the available adjustable rate mortgages are:

1 – month ARM – is an adjustable rate mortgage, where the first adjustament is made after the expiration of the first month. The adjustments that follow are executed on a monthly bases.

6 – month ARM – a form of ARM mortgage, where the first adjustament is made after six months. The adjustments that follow are executed every six months.

3/3 and 3/1 ARM – using this type of mortgage means that the monthly payments and interest rate will not change during the first three years of the mortgage. Beginning from year 4, interest rate is adjusted every three years for the 3/3 ARM. Whereas the interest rate for 3/1 ARM is adjusted every year.

5/5 and 5/1 ARMs – are type of adjustable rate mortgages where the monthly payments (as well as interest rate) remain the same for the first five years. From the beginning of year six, the interest rate is adjusted every five years for the 5/5 ARM and every year for the 5/1 ARM.

10/1 ARM – represent a mortgage with fixed interest rate for the first ten years. After the expiration of the ten year period, the interest rates will adjust each year until the mortgage is paid off.

15/15 ARM – is an interesting type of adjustable rate mortgage. Namely, an interest rate adjustment is made after 15 years. The interesting part is that it is the first and only adjustment that will be made for this type of loan.

Balloon mortgages – have shorter repayment life, and in general work similar to a fixed rate mortgage. As the name suggests, there is a balloon payment on this type of mortgage. This balloon payment is paid at the end of the repayment period. Consequently, the monthly payments are much lower, and consists mostly from interest charged. The major aspect that should be considered before applying for a balloon mortgage is to have enough funds for payment of balloon payments at the end of loan life.

2- Step mortgage – is a form of adjustable rate mortgage consisted from two parts (steps). This mortgage has same interest rate for a portion of the mortgage, while it has different interest rate for the remaining portion of the mortgage loan. The variable interest rates changes in accordance to the market rates.

Going through the types of adjustable rate mortgages it is obviouse that the adjustament period can be as short as one month or as long as couple of years. This means that you can chose the adjustment period based on your needs. Keep in mind though that one year adjustable rate mortgage is much riskier option than a five year adjustable rate mortgage. The riskiness is higher with the one year ARM because your monthly payment could change significantly from year to year during the mortgage life.

Benefits of Adjustable rate mortgage

  • The decrease in interest rates – one benefit could be the possibility for decrease in the market interest rate. Meaning that you could enjoy the benefit of lower monthly payments if the interest rate is decreasing during the adjustment period. Unlike the fixed rate mortgage, where you will pay the same monthly payment.
  • Starting interest rate – on adjustable rate mortgage is, generally, lower that the interest rate charged on the fixed interest rate mortgage.
  • Lower initial monthly payments – because this type of mortgage has lower interest rate, it also has lower monthly payment (until the adjustment is made, afterword depends on the market rate) compared to the fixed rate mortgage.

Risks associated with ARM

  • Risk of increase in market interest rate – will result in increase in your monthly payment as well as an increase in the overall cost of your loan.
  • Monthly payments – can be stable and lower during the period of fixed interest rate. Afterwords it can constantly change depending on the direction of adjustments made to the interest rates.
  • Negative amortization – is one of the major drawbacks of ARM’s. Meaning that, although you are protected by the payment cap, any remaining interest not included in the monthly payment will be added to your outstanding balance.

There are many things that should be considered before applying for an adjustable rate mortgage. First and foremost, make sure that you understand how ARM’s work, and get familiar with the basic terminology. More important, try to understand the characteristics. Adjustable rate mortgage can be beneficial but they could also pose a risk for your financial health. This is primarily because of the possibility for negative amortization. Before deciding on taking out an ARM get acquainted with the expectations related to the interest rate movement in the future. Always make an informed decision, if you do not understand the financial products, maybe it would be wiser to talk with a professional.