An adjustable-rate mortgage, often referred to by its acronym ARM, is a home-loan that offers the borrower a short introductory period with a low fixed interest rate, after which the rate becomes adjustable, i.e. it fluctuates.
Some adjustable-rate mortgages are exposed to fluctuations from day one, but they are less common. An adjustable-rate mortgage with an initial fixed period is known as a ‘hybrid-ARM’.
The term ‘adjustable-rate mortgage’ is common in the United States. In the United Kingdom and other native-English-speaking nations, lay people and lenders tend to say ‘variable-rate mortgage’.
If you answered ‘Yes’ to the questions in red, you might be better off with a fixed-rate mortgage.
After the introductory period is over, ARMs can become a bit of a gamble, experts say. If the base rate remains the same or goes up, the borrower’s interest rate, and thus monthly payment amounts, will rise significantly.
If interest rates decline, the mortgagor’s (borrower’s) payments will either stay the same or could even drop.
Potential disadvantages of an adjustable-rate mortgage
Interest rates – will probably go up after the introductory fixed period is up. The increase is likely to be steep and unpleasant.
Lifetime cap – eventually the interest rate will probably climb to as high as the lifetime cap.
Borrower’s circumstances – most borrowers expect their financial situation will improve with time. If this does not happen, they could be in trouble when the monthly payments shoot up.
Prepayment penalty – this means the borrower cannot pay off the loan in full early, without facing a penalty charge. Many ARMs have a prepayment penalty included in the contract. Borrowers will have to pay a prepayment penalty if they wish to refinance or sell their home.
Advantages of an adjustable-rate mortgage
Costs – overall, adjustable-rate mortgages are cheaper than fixed-rate mortgages, i.e. over the whole term of the contract the borrower ends up paying less.
Falling rates – if you expect interest rates to fall, your monthly payments may also fall. However, bear in mind that mortgages typically span several decades. Predicting where interest rates will be in one year’s time is hard enough, forecasting five or ten years in the future is impossible.
Bigger loans later – getting an ARM can help the borrower qualify for a higher loan amount in future, and therefore a more expensive house. This will only happen if installments are paid on time.
Things to consider
Before considering obtaining an ARM, the Consumer Financial Protection Bureau, part of the US government, advises potential borrowers to find out:
– How high interest rates and monthly payments can go each time the rate is adjusted.
– How often the interest rate will adjust.
– When the higher payments will begin.
– Whether there is a cap on how high interest rates can go.
– Whether there is a limit on how low interest rates can go.
– Whether they will still be able to afford the payments if the interest rate and payments hit their maximums allowed under the loan contract.
Video – Fixed vs. Adjustable Rate Mortgages
This Bank of America video looks at the pros and cons of fixed and adjustable rate mortgages.