Adjustable Rate Mortgage
Adjustable rate mortgages are readily available from many lenders, and homebuyers regularly use these mortgages to purchase both primary and secondary residences. While there are other financing options available, some people prefer adjustable rate mortgages because they generally offer a lower interest rate on the amount that’s borrowed.
Adjustable Rate Mortgages Have a Changing Interest Rate
The defining characteristic of adjustable rate mortgages is their interest rate. Regardless of other options and features that these loans may or may not have, all of these mortgages come with an interest rate that changes over the duration of the loan. These mortgages may also be called ARMs or variable rate mortgages.
The baseline that determines how an adjustable rate mortgage’s interest rate changes is an index. There are three main indexes that lenders use, the Libor rate, the one-year Treasury bill and the fed funds rate, and lenders add on a certain amount to this index rate. The amount that’s added and which fund is followed are stated in a mortgage’s terms and conditions.
For example, a mortgage that’s pinged to the Libor rate might run 2 or 3 percent higher than that index. If the Libor rate is at 0.75 percent, the mortgage’s actual interest rate could be anywhere from 2.75 to 3.75 percent (and perhaps even outside that range).
Depending on the terms and conditions of a mortgage, there are often other conditions that can limit how the associated interest rate changes. For instance, a mortgage might have a rate adjustment only once per year and that adjustment might be limited to a 1-percent change even if the index experiences a bigger fluctuation.
Adjustable Rate Mortgages Are Different From Fixed Rate Mortgages
The interest rate changes that accompany adjustable mortgages distinguish these home loans from fixed rate mortgages.
Fixed rate mortgages come with a set interest rate that’s determined when the loan is underwritten. The interest rate doesn’t change over the course of a fixed rate mortgage regardless of how much the index that it was initially set by might fluctuate.
Adjustable Rate Mortgages Come With Potential Risk and Reward
The difference between adjustable rate and fixed rate mortgages is a matter of who assumes market risk and the corresponding reward.
With a fixed rate mortgage, risk is shifted from the homebuyer and to the lender. Should rates increase, the homebuyer has the certainty that their interest rate won’t change and the lender will miss out on charging a higher rate. For this benefit, homebuyers typically pay slightly higher interest rates when taking out a fixed rate mortgage.
With an adjustable rate mortgage, the homebuyer assumes some of the risk that rates could rise. In exchange for taking on this risk, they both benefit if rates decrease and typically get a slightly lower interest rate than is currently available through a fixed rate mortgage.
Taking on the risk of changing interest rates isn’t right for every homebuyer, but those who have the financial means to absorb this risk might save a lot by getting an adjustable rate mortgage. Even a slightly lower interest rate on an adjustable rate home loan could yield huge savings over the course of the mortgage.
There Are Many Different Types of Adjustable Rate Mortgages
Aside from their defining characteristic of an interest rate that changes periodically, there are many different ways adjustable rate mortgages may be structured. Not only can the borrowed amount be whatever a lender is willing to finance, but the way these mortgage’s rates are adjusted also can differ.
One common type of adjustable rate mortgage is a “5/1 ARM.” With this setup, the mortgage’s rate remains constant for five years and then adjusts once per year thereafter.
Other common types of adjustable rate mortgages are 3/1, 7/1, 10/1 and 15/15 ARMs. In each of these cases, the first number is how many years the initial rate remains in place and the second number is how frequently the mortgage can change expressed in years.
Some adjustable rate mortgages also come with caps, which is expressed via three numbers. A 5/2/5 cap would mean the first adjustment could be up to 5 percentage points, each adjustment thereafter is limited to 2 percentage points, and the total interest rate can’t exceed 5 percentage points above the initial rate.
Secure an Adjustable Rage Mortgage for Your Next Home
If you’re buying a new home, find out what adjustable rate mortgage options are available to you. These might save you thousands of dollars or more over the course of your mortgage if you’re able to take on the risk associated with them.