Finance Blog

Adjustable Rate Mortgages

Mortgage, Personal Finance

An adjustable rate mortgage (also called ARMs) has an interest rate that fluctuates over time. Typically, the rate adjusts once every six or twelve months, though some may change more frequently.

The interest rate of an ARM is tied to an index such as the one-year US Treasury bill or LIBOR (The London Interbank Offered Rate Index).  When the interest rate of the index goes up or down, so does the interest rate of the ARM.

This means that your monthly payment can rise and fall along with interest rates.  Some borrowers can not handle the uncertainty of changing payments. If you are strapping yourself to make your current payment, what are you going to do if rates shot up? Many a borrower has had to sell their home because they could not afford the higher payments.

On the other hand, if interest rates were to go down your monthly payment could decrease nicely.  You would be able to enjoy the benefits of a lower rate and payment without the added expense of refinancing.

Another benefit to adjustable rate mortgages is that the beginning interest rate is lower than that of a fixed rate mortgage. This means that you can borrow more money while maintaining the same monthly payment. More money equals more house. Of course, if interest rates start skyrocketing you may find yourself unable to handle the higher payments.

Lenders are willing to give you a lower rate on ARMs because you are accepting the added risk of an adjustable rate. The initial interest rate on an adjustable rate mortgage should be significantly lower than the interest rate on a fixed rate mortgage.

You should read the loan documents carefully so you know how much the interest rate can rise. Ideally, your ARM should contain both a Periodic Rate Cap and a Lifetime Cap.

A periodic rate cap limits how much your rate can rise in any one cycle. For example, say your rate is adjusted once a year and your periodic rate cap is 2 percent. Even if interest rates were to shoot up 3.5 percent, they could only raise your rate by 2 percent each year.

A lifetime cap sets a maximum limit on how high the interest rate can go during the life of the loan. So if you took out a loan at 6.25 percent with a lifetime cap of 6 percent, the highest your rate could ever go would be 12.25 percent.

That may seem like a high rate by today’s standards, but in the early 1980’s interest rates were as high as 16 percent. If that were to happen again, you’d be in good shape because your rate would only go to 12.25.

Another thing to keep in mind is the length of the introductory rate. Usually, the initial rate is fixed for a set number of years before it begins to adjust. The period usually lasts between three and seven years.

This can be a great advantage to homeowners who only plan to stay in their house for a short time before moving. They can enjoy the benefits of the low teaser rate, and then sell the house before the interest rates even have a chance to rise.