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Adjustable Rate Mortgages
Updated and reviewed April 23, 2013
An adjustable rate mortgage, often called ARM, has an interest rate that is not fixed. The interest rate varies based on one or many indexes. This could be to the one-year treasury bills or to another specific index. You may note that different lenders tie the adjustable rate to different indexes.
Examples of some quite common indexes are:
- Treasury notes and bills
- The Federal Housing Finance Boards National Average mortgage rate, which is an average rate for loans closed.
- The average interest rate paid on jumbo certificates for deposit. It may also be based on the costs of funds for the specific lender.
Many of these indices that the adjustable rates are typically based on are published in the newspaper. Before going for an adjustable rate mortgage, check where you can find the published adjustments, if there are any types of sources for projections, and where the underlying index on which the adjustable rate is based is posted.
It goes without saying that the interest rates can go up or down. Therefore this type of mortgage loan can be a very viable option for people who are not too sensitive to fluctuating financing costs. Shopping for an adjustable rate mortgage can be more difficult than shopping for a fixed rate mortgage.
What are the advantages of an adjustable rate mortgage?
With a lower adjustable interest rate the monthly amount will be less. You may therefore qualify for a larger mortgage, or you may qualify for a loan easier. Lenders use your gross monthly income and your monthly mortgage payment to determine how much you can qualify for.
Given that you plan to stay in the home for a limited time period, a couple of years or so, an adjustable mortgage may be a great option. The main parts of benefits of an initial low interest rate will be gained during this period.
If current interest rates are very high, this could be the only loan choice available to you. But if you are risk avert, maybe this is not be the option for you.
The fine print of an adjustable mortgage loan
It is important that you study the details of the loan; below you find some of the basics and terminology explained. In summary when looking at an adjustable mortgage rate you should consider in addition to basic rate and index information:
- Initial rates
- Adjustment intervals
- Rate caps and payment caps
Intial rate or teaser rate
The initial rate you are charged on the loan is generally lower than current interest rate. This can be an excellent way of purchasing a home you may not be able to get a fixed rate loan for, as the initial payments will be lower. As mentioned, when the bank is deciding how large of a mortgage you qualify for they base this on the monthly payments you can afford each month. Therefore a low initial rate on an adjustable rate mortgage can help you qualify for this type of loan but not for a fixed rate mortgage.
At the end of the initial rate term your interest rate will be based on the indexes specific for your loan. This index (or indices) is not the actual percentage interest rate you will be paying, but rather the basis on which they are calculated. In most cases some sort of a margin must be added to this to give the actual interest rate. This margin may vary. The index plus the margin will give the actual adjustable rate that the interest defaults to after the initial term.
Interval of adjustment
Be sure to ask for and understand the interval of adjustment for you mortgage. If the interval is one year, then the interest rate for the mortgage remain the same for one year and then changes in accordance with the index (and the margin). The mortgage rate will continue to adjust for the entire term of the mortgage.
Rate cap and payment cap
Besides margin and adjustment intervals, be sure to find out everything about rate caps. A rate cap is the maximum percent increase that can occur at each interval of adjustment. A payment cap is the maximum amount that your payment can go up at each adjustment interval.
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