Understanding an Adjustable Rate Mortgage

An adjustable rate mortgage (ARM) is exactly what the name implies; a home mortgage loan with an interest rate that is adjusted during the life of the loan. 

If you go out looking for an adjustable rate mortgage, the lender will usually have two identifying numbers associated with the loan offer; such as 1/1, 3/1, 5/1, 2/28, or 3/27.   These are some common numbers associated with adjustable rate mortgages, but there are others as well. 

The first number indicates the number of years that the adjustable rate mortgage will operate like a fixed rate mortgage until it comes up for its first interest rate review.  The second number indicates the interval at which the mortgage will be reviewed thereafter.   For example a 5/1 ARM means that the interest rate given at the time of securing the loan is guaranteed for the first five years of the mortgage, and then the rate will be reviewed and adjusted in one year intervals.  However, a 2/28 means the initial rate is fixed for 2 years and then the loan adjusts for the remaining 28 year term.  In this situation, the adjustment period may be once a year or even every six months. 

When seeking a home mortgage, you will have a choice of adjustable rate mortgage, like we described above, or a fixed rate mortgage.  Unlike an adjustable mortgage, a fixed rate mortgage will remain at the same interest rate for the entire life of the loan. 

Before choosing an adjustable rate mortgage, it is important to understand that they have both advantages and disadvantages and the choice of which type of mortgage is best for you will be largely determined by the current market as well as your own situation.

Look at the Index and Margin

A very important consideration in selecting an ARM is the index and margin.  The index is the fluctuating value that is the basis for the rate.  Common indexes are Prime Rate, 1 year Treasury Bill rate, LIBOR, and MTA.  Unfortunately, one of the most common indexes is the LIBOR (London Interbank Exchange Rate) and it is also the most volatile. 

The margin is the amount that is added to the index at the time the interest rate re-prices (or adjusts)  FHA has the lowest margin at 2.0% and common margins for conventional loans are 2.25% and 2.375%.  Obviously, when comparing two loans with the same index, one with a 2.25% margin and one with a 2.375% margin, the lower margin loan will be the cheapest.  The crash in the subprime market in 2007 was caused by many factors.  One of the factors was the margins on those loans.  Subprime loans was commonly written at margins of 5%, 6%, or 7%.  They were also commonly 2/28 loans with LIBOR indexes.  Prior to and during the credit crash of 2007, LIBOR rates were 5+%.  As subprime loans re-priced at margins of over 6%, these loans were re-pricing to sometimes as high as 13.5%.  No wonder may subprime borrowers were forced into foreclosure.

 Advantages of Choosing an Adjustable Rate Mortgage 

By far, the greatest advantage of an adjustable rate mortgage is that it usually begins at a lower initial interest rate than a fixed rate mortgage loan.  Because the mortgage lender does not have to guarantee the interest rate for the entire life of the loan, he is freer to offer the lowest possible interest rate. Therefore, if you do not intend to hold your mortgage for more than a few years, it might be worthwhile to choose an adjustable rate mortgage and get the lowest rate possible. 

There is a caveat to this situation.  In an unusual market condition called an inverted yield curve, the longer term interest rates may be lower than short term rates.  Normally the yield curve is steep but in times of economic uncertainty, the curve may flatten or even invert.  This is normally a rare circumstance but the curve was very flat in 2005. 

There is another advantage to an adjustable rate mortgage, but it is present only in a high interest rate market.  If you are securing a mortgage during a time when the mortgage rate being offered is high, by choosing a fixed rate mortgage you would be locked to that high rate for the entire life of the loan.  If you choose an adjustable rate mortgage; however, when the market declines, your mortgage rate will decline as well.  

Disadvantages of Choosing an Adjustable Rate Mortgage 

The main reason that many borrowers will not even consider an adjustable rate mortgage is because of the risk level involved with this type of borrowing. With an adjustable rate mortgage, not only is there the chance that your interest rate and monthly mortgage payments will go down, but there is also the chance that they will go up. If the payment goes up too high, the borrower may not be able to make the payments and may fall delinquent on their payments and damage their credit rating.  If the borrower get too far behind, the lender may commence legal action to recover the property.  For the homeowner who is not comfortable with the risk, and needs to know that their monthly mortgage payments will never change, an adjustable rate mortgage would not be the best choice.  On a $200,000 loan a change of 1% in the interest rate to 6.5% make a difference in monthly payment of $129.

Summary

Adjustable rate mortgages are not for everybody.  The initial low rate can readjust and the borrowers rate can go up significantly.  However, if the borrower has plans to sell their home, then an ARM can make sense.