Adjustable Rate Mortgage Basics

Some people are gamblers by nature. They realize the risk. They realize the reward, and often the attraction of the reward outweighs the risk.

For anyone with a more conservative viewpoint, the attraction of the reward would never outweigh the risk of a bet.

This is a simple way of looking at an adjustable-rate mortgage (ARM). Like any bet, it can pay off over time, or it can end up costing you more than if you would have played it safe.

An adjustable-rate mortgage (ARM) has an interest rate that changes periodically (the gamble); as opposed to what many would consider a safer play, the fixed-rate mortgage, which has an interest rate that stays the same during the life of the loan.

With a fixed-rate mortgage, you know what you’re going to get. An ARM can be more unpredictable.

An ARM has many factors tied to it that determine the interest rate and payments.

The interest rate is the sum of the index and the margin. An index is the measure of the interest rate, and usually the index is what makes the interest rates fluctuate over time. The margin is the extra amount the lender adds.

For example, if the initial index was 4 percent, and the margin was set at 2 percent, the interest rate – or fully indexed rate – would be 6 percent.

Margins typically differ from one lender to another, but once set, they stay the same throughout the life of the loan.

The enticement of an ARM is usually a low initial interest rate. Some lenders even make the initial rate lower than the actual fully indexed ARM rate, which is called a teaser rate. The interest rate will rise and fall over time, depending on the index; however, even if interest rates are stable, the rates and payments could still change a lot.

The time in between when the initial rate and payment amount changes varies with each loan. It can range from one month to five years or more. Once a lender or broker quotes the initial rate and the payment of a loan, you can ask for an annual percentage rate (APR). An APR significantly higher than the initial rate is an indication that the rate and payment will be much greater when the loan adjusts.

Once the initial change occurs, how often the rate and payment change after that depends on the adjustment period. Every loan has a different adjustment period, which is determined at the beginning of the loan. Adjustment periods are typically every month, quarter, year, three years or five years.

The amount the interest rate can change is limited by an interest-rate cap. Interest-rate caps are either a periodic-adjustment cap or a lifetime cap, and a loan can have both. A periodic-adjustment cap limits the amount an interest rate can change – up or down – between adjustment periods after the first adjustment. A lifetime cap limits the maximum interest rate over the life of the loan, and by law, almost all ARMs must have a lifetime cap.

If interest rates rise more than a periodic adjustment cap allows, the leftover amount could be applied to a future rate adjustment, which is called a carryover.

For example, let’s say you have a 6 percent interest rate and a 2 percent periodic adjustment cap. Interest rates go up to 9 percent during the next adjustment period; however, since you have a cap, you’re interest rate can only go up to 8 percent.  For the next adjustment period, the interest rate is at 9 percent. Instead of going up to just 9 percent, your interest rate would go up to 10 percent to account for that leftover 1 percent.

ARMs also have a payment cap that limits what you pay for your monthly payment. So if you have a 5 percent payment cap, and the interest rate goes up from one adjustment to the next and makes your next payment go up 10 percent, you would only pay 5 percent more. That leftover amount is added to the balance of your loan. In some scenarios, the balance of the loan could become more than you actually borrowed, which is referred to as negative amortization.

Obviously, there are risks with any adjustable-rate mortgages; however, that does not mean you should always stay away. They make sense for anyone who is looking to only stay at their current house for a short time period, or for someone with a fluctuating income who could deal with fluctuating rates.

To get a better idea of how those rates and payments will change over time, ask your lender for a chart or graph of its historical rates.

Even with that information, know that choosing an ARM is a gamble.