How Do Adjustable Rate Mortgages Work?

An ARM, or adjustable rate mortgage, is a mortgage financing option that comes with an interest rate that fluctuates over time. Normally, the interest rate will adjust once every six or twelve months. However, there are mortgages of this type that may change more frequently.

The mortgage interest rate for an ARM is linked to an index such as the one-year US Treasury bill, or The London Interbank Offered Rate Index (LIBOR). When the interest rate of the linked index raises or lowers, so will the interest rate of the adjustable rate mortgage.

How does this affect the borrower? This means that the monthly mortgage payment will also rise and fall right along with the interest rate of the index. This fluctuation can cause serious problems for the borrower. Many borrowers cannot afford to live with the uncertainty of changing payments. Should the borrower have chosen the ARM in order to qualify for an affordable mortgage, what happens if the interest rate shoots up? Should the increased payments become too much, the borrower may find themselves being forced to sell their home.

If interest rates were to go down however, the monthly mortgage payment may decrease considerably. The borrower can now enjoy the benefit of a lower interest rate and mortgage payment without having to refinance.

The most appealing benefit to an adjustable rate mortgage is the lower beginning interest rate when compared to a fixed rate mortgage. This means that the borrower can receive more money while maintaining the same monthly payment. More money translates into more house. Very appealing! Of course, should interest rates raise considerably the borrower may find themselves no longer able to make the higher payments.

Lenders are willing to offer a lower rate on ARMs because the borrower accepts the added risk associated with an adjustable rate. The borrower must read the loan documents very carefully and completely understand how much the interest rate can rise. Ideally, a borrower would like the ARM to contain a Periodic Rate Cap, a Lifetime Rate Cap, and the option to refinance to a fixed rate at any time during the lone term.

What is a Periodic Rate Cap? The Periodic Rate Cap will limit how much your interest rate can increase in any one cycle. For example, should your interest rate be adjusted annually and your Periodic Rate Cap is 2 percent, then even if interest rates were to rise by 3.5 percent, your mortgage rate could only be increased by 2 percent each year.

What is a Lifetime Rate Cap? This type of cap sets a maximum limit on how high the interest rate can be raised during the life of the mortgage loan. For example, should you take out a mortgage at 6.25 percent with a lifetime cap of 6 percent, the highest your rate could ever go would be 12.25 percent.

By today's standards that may seem to be a very high rate. However, in the early 1980's interest rates were as high as 16 percent. Should the economy cause that to happen again, a borrower with a mortgage loan like the one used in our example would be in good shape because their interest rate could only go as high as 12.25 percent.

Usually, the initial rate offered in an adjustable rate mortgage remains fixed for a set number of years before beginning to adjust. The period may be anywhere from two to seven years.

This is a great advantage to homeowners who plan to stay in their home for only a short time before moving. They are in the position where they can enjoy the benefits of the lower "teaser rate", that results in a lower mortgage payment, and then sell the house before the interest rates have a chance to rise.

Copyright 2007 Carl DiNello