Adjustable Rate Mortgages
What is an Adjustable Rate Mortgage?
An adjustable-rate mortgage (ARM), also known as a variable-rate mortgage or tracker mortgage, is a loan with an interest rate that can go either up or down depending on market conditions. These market conditions are based on an underlying index like the federal funds rate, treasury bills, or LIBOR. The change in rates accounts for the costs of borrowing from the market for the lender.
Each lender decides how many points they’ll add on top of the index rate, which would be their margin. The lender will also determine periods at which the rate will be due for an adjustment. Periods of adjustment (known as “resets”) may occur monthly, quarterly, annually, every three years, etc. The borrower needs to understand and anticipate these periodic adjustments.
What's the advantage of an adjustable rate mortgage?
An ARM’s main advantage is that it’s usually cheaper than a fixed-rate mortgage. This is because the borrower is risking increases in the market cost of borrowing. A clear disadvantage is if the index rate, federal funds rate, treasury bill, or LIBOR rate, rises faster than your income. To mitigate this risk, you could put a cap on interest rates.
How is the interest rate determined?
The interest is determined by the lender. The lender states the index that the ARM would track, then adds a fixed margin (percentage points) to the index rate. The lender's margin doesn’t change, but the index might. For example, in the contract, the lender would state that the ARM is three percentage points above the LIBOR. So, if the LIBOR is at 0.75, then the interest rate is at 3.75.
When does the rate change on an ARM?
The contract determines when the rate will change. The change in an interest rate is called a “reset.”
The periods in which the rate is due for an adjustment could be in months or years. Some ARM contracts have a period in which the interest rate is fixed, before the reset periods. These are called hybrid ARMs. So, you could end up with a 20-year mortgage that starts with a 5-year fixed interest rate, then a variable rate for 15 years (adjustable annually based on LIBOR movements).
What are interest rate caps, payment caps, and interest rate floors on ARM?
An interest rate cap limits by how much the rate can go up in a period. There are generally two types of interest rate caps:
A periodic adjustment cap limits the interest increase in a period. For example, your ARM could have a 0.5% increase cap per year, no matter how much the underlying index rate has moved up.
A lifetime cap limits the interest rate increase throughout the term of the ARM.
If the index goes up above the cap in a period, the rate will increase according to the cap until it equals the index increase. For example, if the cap is 0.5% per year and the index increases by 1.5%, then the rate will increase by 0.5% per year over three years until it matches the 1.5% index increase.
A payment cap limits the interest amount that you pay. It can be expressed as a dollar amount (e.g., $100 per period) or as a percentage (e.g., 10% per period).
Some ARMs have an interest rate floor, which is the minimum rate that you’ll pay, no matter how much the index declines. This is usually your initial rate or the rate paid during the fixed interest rate period.