Adjustable rate mortgages (ARMs) are home loans with a rate that varies. As interest rates rise and fall in general, rates on adjustable rate mortgages follow. These can be useful loans for getting into a home, but they are also risky. This page covers the basics of adjustable rate mortgages.
Adjustable rate mortgages are unique because the interest rate on the mortgage adjusts with interest rates in the marketplace. This is important because mortgage payment amounts are determined (in part) by the interest rate on the loan. As the interest rate rises, the monthly payment rises. Likewise, payments fall as interest rates fall.
The rate on your adjustable rate mortgage is determined by some market index. Many adjustable rate mortgages are tied to the LIBOR, Prime rate, Cost of Funds Index, or other index. The index your mortgage uses is a technicality, but it can affect how your payments change. Ask your lender why they’ve offered you an adjustable rate mortgage based on a given index.
Adjustable Rate Mortgage Benefits
A main reason to consider adjustable rate mortgages is that you may end up with a lower monthly payment. The bank (usually) rewards you with a lower initial rate because you’re taking the risk that interest rates could rise in the future. Contrast the situation with a fixed rate mortgage, where the bank takes that risk. Consider what happens if rates rise: the bank is stuck loaning you money at a below-market rate when you have a fixed rate mortgage. On the other hand, if rates fall, you’ll simply refinance and get a better rate.
Pitfalls of Adjustable Rate Mortgages
Alas, there is no free lunch. While you may benefit from a lower payment, you still have the risk that rates will rise on you. If that happens, your monthly payment can increase dramatically. What was once an affordable payment can become a serious burden when you have an adjustable rate mortgage. The payment can get so high that you have to default on the debt.
Managing Adjustable Rate Mortgages
To manage the risks, you’ll want to pick the right type of adjustable rate mortgage. The best way to manage your risk is to have a loan with restrictions and “caps”. Caps are limits on how much an adjustable rate mortgage can actually adjust.
You might have caps on the interest rate applied to your loan, or you might have a cap on the dollar amount of your monthly payment. Finally, your loan may include a guaranteed number of years that must pass before the rate starts adjusting – the first five years, for example. These restrictions remove some of the risk of adjustable rate mortgages, but they can also create some problems.