Adjustable-rate mortgage

An adjustable rate mortgage or variable rate mortgage is a loan secured on a property (house) whose interest rate and so monthly repayment vary over time. Other forms of mortgage loan include interest only mortgage, fixed rate mortgage, Negative amortization mortgage, discounted rate mortgage and balloon payment mortgage. Adjustable rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls and loses out if interest rates rise.

Variable rate mortgages are the most common form of loan for house purchase in the United Kingdom but are unpopular in some other countries. Variable rate mortgages are very common in Australia and New Zealand. For those who plan to move within a relatively short period of time (three to seven years), they are attractive because they often include a lower, fixed rate of interest for the first three, five, or seven years of the loan, after which the interest rate fluctuates.

Adjustable rate mortgages, like other types of mortgage, may offer the ability to repay principal (or capital) early without penalty. Early payments of part of the principal will reduce the total cost of the loan (total interest paid), and will shorten the amount of time needed to pay off the loan. Early payoff of the entire loan amount (refinancing) is often done when interest rates drop significantly.

Adjustable rate mortgages are sometimes sold to unsophisticated consumers who are unlikely to be able to repay the loan should interest rates rise, which they often do. In the United States, extreme cases are characterized by the Consumer Federation of America as predatory loans. Protections against interest rate rises include (a) a possible initial period with a fixed rate (which gives the borrower a chance to increase his/her annual earnings before payments rise); (b) a maximum (cap) that interest rates can rise in any year (if there is a cap, it must be specified in the loan document); and (c) a maximum (cap) that interest rates can rise over the life of the mortage (this also must be specified in the loan document).

The Hybrid ARM

What is the difference between a hybrid and a traditional ARM

 THE dominant loan product in today's marketplace.  They are often packaged as the 5/1 ARM or the 2/28 ARM (most popular products).   The loan is a "Hybrid" because a true ARM adjusts for the same periods for the life of the loan, ie. a 6 Month ARM is fixed for the first six months and adjusts every six months afterwards.  The 2/28 "Hybrid ARM" is a 6 month ARM that the borrower has purchased a "Rate Lock" or introductory rate for the first 2 years (this is also done in 3,5,7 year fixed periods), and then the loan becomes a 6 month ARM thereafter, rather than a loan that does only adjust every 2 years.  

The benefits

 This loan product has actually lowered the costs of borrowing in the early years of loans, but certainly is a source of continuing refinance business to the Mortgage industry.  They let borrowers take advantage of special pricing, by saving money on payments when the borrower's a) salary is rising such as for young professionals or b) when the borrower knows they are going to move up quickly from one home to another.

The risks

 If a borrower is inconsistent in their on time payment history, afflicted by tragedy which causes a credit problem, or keeps insufficient funds in reserve (the payment savings from the lower rate for example), as referenced above, the rates in Hybrid ARMs will certainly rise, and with insufficient credit and income, the borrower may be forced to trade equity for time, and in some markets, not as advantageously as today.  

Terminology

• Fully Indexed Rate - The price of the ARM as calculated by adding Index + Margin = Fully Indexed Rate. This is the interest rate your loan would be at without a Start Rate (the introductory special rate for the initial fixed period). This means, your loan would be higher today if it was adjusting, typically, 1-3% higher than the introductory rate. Calculating this is IMPORTANT for ARM buyers, since it helps you predict the future interest rate of your loan.

• Margin - This refers to the banks profit margin above the value of the financial index. The bank seeks to make a profit above the costs of inflation. The index is a measure of the cost of funds as measured by inflation.

• Index - A publicly published financial index such as LIBOR (usually 1 month, 6 month or 12 month), 11th District Cost of Funds Index, MTA, etc.

• Start Rate - The introductory rate provided to purchasers of ARM loans for the initial fixed interest period. The difference between the "Start Rate" of an ARM and the rate of a fixed terms loan is that the "Start Rate".

• Floor - A clause that sets the minimum rate for the interest rate of an ARM loan. Most loans come with a Start Rate = Floor feature, but this is primarily for Non-Conforming (aka Sub-Prime or Program Lending) loan products. This prevents an ARM loan from ever adjusting lower. An "A Paper" loan typically has either no Floor or 2% below start.

• Cap - Any clause that sets a maximum change for the interest rate of an ARM loan.

Understanding Caps

• "The Caps" - In industry slang, there you could ask for the Caps of a loan, and if your broker or loan officer is intelligent enough to read the rate sheets they are quoting from, it is ALWAYS displayed and available.

Examples: 2/2/5 5/2/5 - 3/1/6 - 2/4

 The first number is the initial change cap, the second is the 

• Initial Change Cap - Arm loans have a specified maximum first adjustment that is typically higher than allowed on subsequent changes.

External links

• Consumer Handbook on Adjustable Rate Mortgages (PDF Document)
• Historical Mortgage Rates, 1977 - present
• Mortgage, Loan and Refinance Information: A Borrower's Guide to Online Resources.