Mr. Unpredictable: Adjustable Rate Mortgages
Written by James Chan   


An Adjustable Rate Mortgage (ARM), is also known as a Floating Rate Mortgage, Flexible Rate Mortgage, or Variable Rate Mortgage. In an ARM, the interest rate fluctuates throughout the term of the loan – usually once per year – based on some index, such as US Treasury bond rates. ARMs grew in popularity before the housing crisis, but many are now in default.


Interest Rate

ARM's typically come with a fixed rate period, such as a 1-1, 3-1, or 5-1 ARM (these are also referred to as a hybrid ARM).  That means the rate is fixed for the first X years and then resets every Y years.  This is known as the X-Y structure, where X is known as the initial period, and Y is known as the adjustment period. For example, a 5-1 ARM means that the interest rate will remain the same for the first 5 years, and then adjust every year thereafter.

The interest rate is usually the rate of a certain market index plus a margin on top of that rate. For example, a one year T-Bill (short term US debt) plus a 2% interest rate means that the interest on your ARM mortgage will be the Treasury bill rate during the beginning of the adjustment period plus 2%. Almost all ARM mortgages base their rates on a certain market index, such as 1-year, 3-year, or 5-year Treasury securities (longer-term US debt).  It is crucial to figure out which index the lender goes with early on.

Beware! The initial interest rate when you first take out the mortgage is ALWAYS lower than the adjusted interest rate once the initial rate ends. It is also lower than the fixed rate in an effort for banks to entice you into buying a mortgage product you don’t understand, similar to the 0% APR financing offers you see in car commercials. Immediately before and during the current housing crisis, many homeowners were forced into foreclosure due to ARM interest rate adjustments, so be careful before you jump at the seemingly lower rates.


Elements of an Adjustable
  • Term Length: the time it takes to pay off your mortgage in full, 30 years for most fixed term mortgages;
     
  • Principle: the listed house price when you bought the house. Must be paid off in full by the end of the term length of the mortgage, which should happen if you follow the payment schedule;
     
  • Initial Interest Rate: the introductory rate offered by the mortgage; lasts X amount of years for an X-Y ARM;
     
  • Adjusted Interest Rate: once your initial interest rate time period ends, the rate gets adjusted upward, or downwards if interest rates fall. This rate will be reset every set period of time, or Y years in the X-Y ARM model. It is typically a year - and is based on an index rate;
     
  • Index Rate: the rate at which ARM interest rate adjustments are based on. The most common index rates are one, three, and five-year Treasury security interest rates;
     
  • Margin: the number added onto the index rate to compose your ARM mortgage interest rate
Thus, your ARM interest rate is composed of the index rate plus the margin.


ARM Mortgage Pros
  • Low Initial Payments: the introductory ARM rates are lower than comparable fixed rate mortgage interest rates;
     
  • Flexibility: you don’t need to refinance and pay the associated fees when interest rates fall – your ARM interest rate will automatically adjust to match.

ARM Mortgage Cons
  • Unpredictability: as evidenced recently, market rates can fluctuate wildly, which can affect ARM mortgages and hinder long-term budgeting;
     
  • The “adjusted rate”: as mentioned before, when the adjustment period hits, interest rates almost always adjust UP. This can cause families on tight budgets to fall behind on payments or even face foreclosure.

Select the ARM Mortgage If:
  • You expect a rise in income in the future - this especially applies to young people who get significant pay raises as they move up the corporate ladder;
  • You plan to sell your house off within the time period in which you pay the initial interest rate
Beware! Make sure you can actually sell your house off within that time period; this has evolved into a major concern in a slumping housing market.
Last Updated on Wednesday, 22 December 2010 05:19