Understanding Adjustable Rate Mortgages

The mortgage is a popular lending tool used by people who would like to buy a home, but do not have enough money to purchase the home outright. It is actually a very old type of loan, which has been used for thousands of years. For the purposes of this article, however, we will be discussing modern mortgages and specifically the Adjustable Rate Mortgage.

What is an Adjustable Rate Mortgage?

Traditionally, the 30 year fixed rate mortgage has been the standard type of mortgage, with Adjustable Rate Mortgages, or ARMS, actually being rather new. An adjustable rate mortgage differs from other mortgages in that the interest rate of the loan varies, or is adjusted, multiple times throughout the length of the loan. So, rather than having a fixed interest rate the entire length of the loan, with an ARM, the interest rate will be adjusted every few years.

How frequently the interest rate is adjusted varies, but it is usually adjusted 2, 3 or 5. Some subprime ARMs adjust more frequently, but usually the rate is not adjusted more than once every 2 years. When it comes time to adjust the rate, the bank will look at the current market values and use this to either raise or lower your interest rate.

A standard ARM will have a set limit of how much the interest rate can be raised each adjustment, as well as how high the interest rate can be raised in total over the length of the loan. Most Adjustable Rate Mortgages can only be adjusted by 1% each time, although this can vary.

When planning for an Adjustable Rate Mortgage, it is a good idea to assume that the interest rate will be raised each time by the full amount, although this is not always the case. For example, during the current housing market crash, most people with ARMS should have seen their interest rate lower, but this is not the norm.

Advantages of Adjustable Rate Mortgages

One of the main advantages of using an Adjustable Rate Mortgage is that the initial interest rate is usually lower than that of a fixed rate mortgage. For instance, it is not uncommon for an ARM interest rate to be 1% lower than the comparable fixed rate mortgage offered by the lender. This means that for the first two periods of adjustment, an ARM should cost less than a standard fixed rate mortgage. Of course, after three adjustment periods, the interest rate is usually higher than that of a fixed rate mortgage.

This low initial rate is one reason that ARMs are so popular, because it gives the homeowner some breathing room to get more equity into the home or otherwise save money. The downside to this is that eventually the rate will rise, so if you haven’t paid the house down any by this point, it can become more expensive.

The Role of the ARM in Subprime Lending

The Adjustable Rate Mortgage also had a role in the current housing market situation, with a number of subprime ARMs being offered. These subprime mortgages often had much shorter adjustment periods, no limit on how high the rate could climb, and would raise more than 1% at a time. As a result, these loans quickly became unfordable. Another problem was that many included terms that resulted in a drastically increased interest rate after only one missed payment.