What is an adjustable-rate mortgage? Definition and examples

An adjustable-rate mortgage or ARM is a home-loan that offers the borrower a short introductory period with a low fixed interest rate. After the introductory period, the rate becomes adjustable, i.e. it fluctuates.

With some adjustable-rate mortgages, there are possible fluctuations from day one, but they are less common. A hybrid-ARM is an adjustable-rate mortgage with an initial fixed period.

The term ‘adjustable-rate mortgage’ is common in the US. In the UK and other native-English-speaking nations, lay people and lenders tend to say ‘variable-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 will rise. Consequently, the amount they pay back each month will increase.

On the other hand, if interest rates decline, the mortgagor’s payments will either stay the same or could even drop. The mortgagor is the borrower.

Cornell Law School has the following definition of “adjustable rate mortgage”:

“Adjustable rate mortgage (ARM) is a type of mortgage where the interest rate changes over time. In contrast, fixed rate mortgages made for 15, 20, or 30 years have a set amount of interest on the loan that does not change. ARMs come in many different forms. The typical ARM has a fixed interest rate for a specific amount of time. Then the interest rate changes according to the adjustment frequency.”

Real-World Example: The Impact of Rate Adjustments on an ARM

Scenario:

Jane secures a 5/1 ARM to purchase her first home. The loan amount is $200,000. The initial fixed interest rate for the first 5 years is 3.5%. Her monthly payment, primarily focused on interest in the early years, is approximately $898.

Year 6 Adjustment:

After enjoying stable payments for 5 years, Jane reaches the end of her fixed-rate period. The interest rates in the market have gone up, and her ARM adjusts to a new rate of 4.5%. Her new monthly payment becomes approximately $1,013, an increase of $115 per month.

Year 7 Adjustment:

The following year, market rates decline slightly. Her ARM adjusts again, this time to a rate of 4.25%. Her new monthly payment is now about $983, a decrease of $30 from the previous year but still $85 more than her original payment.

Impacts Over Time:

While the initial fixed-rate period allowed Jane to benefit from predictable monthly payments, the subsequent adjustments brought fluctuations. Some years, like Year 6, saw an increase in her monthly expenses, while others, like Year 7, brought some relief.

However, if Jane had taken a fixed-rate mortgage at 4% initially, her monthly payment would have been approximately $955, consistent over the life of the loan. This comparison underscores the trade-off between the initial savings an ARM can offer and the potential unpredictability of future payments.

Adjustable-rate mortgage – drawbacks

Interest rates will probably go up after the introductory fixed period. Furthermore, 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. However, if this does not happen, they could be in trouble when the monthly payments shoot up.

Prepayment penalty – this means that 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. Consequently, borrowers will have to pay a prepayment penalty if they wish to refinance or sell their home.

Adjustable-rate mortgage – advantages

Costs – overall, adjustable-rate mortgages are cheaper than fixed-rate mortgages. Over the whole term of the contract, the borrower will probably end up paying less.

Falling rates – if you expect interest rates to fall, your monthly payments may also get smaller. 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 interest rates for 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. Hence, borrowers can look forward to a more expensive property later in life. However, this will only happen if you pay your installments on time.

Things to consider

Before considering obtaining an ARM, there are several things you should consider. The Consumer Financial Protection Bureau, part of the US government, advises potential borrowers to find out:

  • How high can the interest rates and monthly payments go each time the rate is adjusted?
  • How often will the interest rate adjust?
  • When will the higher payments will begin?
  • Is there is a cap on how high the interest rates can go?
  • Is there is a limit on how low the interest rates can go?
  • Will the borrower be able to afford the payments if the interest rate and payments hit their maximums allowed under the loan contract?