An Adjustable Rate Mortgage is a form of mortgage in which the interest rate fluctuates in line with a chosen index. This means that the mortgage payments will go up or down depending on the interest rate.
The index which is used to determine the interest rate will change from one lender to another. The most common indices are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). Sometimes the lenders may use their own cost of funds as an index.
Since the borrower is bearing the risk of interest rate fluctuations, lenders often give better rates on ARMs than Fixed Rate Mortgages. If the interest rates go down, the interest rates of the loan will go down automatically (without costly refinance) and the borrower will benefit. On the other hand there is also the risk of interest rates going up in future, which may result in a situation where the borrower finds it impossible to pay his mortgages due to the high interest rates.
Comparison Between ARM and FRM
Adjustable Rate Mortgages are less expensive than Fixed Rate Mortgages and sometimes they carry 'teaser periods' in which the interest rates are substantially less than the interest rates for Fixed Rate Mortgages. The teaser periods are anywhere between one month and five years. If the borrower does not expect stay in his house for long, the low interest rates in the teaser period may benefit him.
Adjustable Rate Mortgages are also useful when the existing interest rates are high and rates are expected to go down in future. Another scenario in which an ARM is the better choice is when the borrower expects his income to increase in future. In that case the initial lower payments on Adjustable Rate Mortgages will qualify him for a higher loan amount than what he would qualify for if he had gone for a Fixed Rate Mortgage. Even if the interest rates and the future mortgage payments go up, the borrower will be able to compensate for it with his increased income.
Against these advantages the borrower needs to consider the fact that interest rate may go up, sometimes considerably, in future. The borrower is transferring the rate risk from the lender to himself in return for getting low interest rates in the beginning. If the rates go up, he may not be in a position to afford the higher mortgage payments. This is sometimes called 'Payment Shock'.
Sometimes borrowers simply consider the interest rates in the teaser period while calculating the mortgage payments and may be in for an unpleasant surprise when the teaser period is over and the mortgage payments increase substantially.
Interest-rate Caps for Adjustable Rate Mortgages
If the interest rates go up uncontrollably, the borrower may not be in a position to make his mortgage payments. Interest Caps imposes a limit on the maximum rate that can be increased in an interest rate change and thus protect the borrower against payment shocks. Generally, there are three types of Caps on a mortgage loan.
Initial Adjustment Rate Cap: Most loans have a higher Initial Adjustment Rate Cap. Initial Adjustment Rate Caps are also linked to the initial teaser period. The caps are typically higher for loans with a longer teaser period.
Rate Adjustment Cap: This is the maximum amount by which an Adjustable Rate Mortgage may increase on each successive adjustment.
Lifetime Cap: Most First Mortgage loans have a 5% or 6% Life Cap above the Start Rate.
The Federal Reserve Board site is an excellent source of information for consumers interested in Adjustable Rate Mortgages.
If the interest rates remain stable over the term of the loan or they go down, ARMs can be much less expensive than Fixed Rate Mortgages. However, Adjustable Rate Mortgages are better suited for sophisticated borrowers who knows exactly how much they will have to pay during and after the teaser periods and who are able to handle the fluctuations in mortgage payments without financial difficulty. They are not suited for first-time home buyers or borrowers who do not understand how ARMs work.
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