Adjustable Rate Mortgage Basics

A basic definition for an adjustable rate mortgage is as follows:  An adjustable rate mortgage is a mortgage loan whose interest rate varies over time.  The interest rates for most common types of adjustable rate mortgages (ARMs) typically change every six months or a year, but some ARM rates can vary monthly.

The rates of adjustable rate mortgages mostly depend on general interest rates in the markets.  By signing on to an ARM, the borrower takes on a risk that rates may go up in the future.  This risk is rewarded with interest rates that are lower than current rates of newly issued fixed rate mortgages (FRM), which are mortgages whose interest rated do not change through out the life of the loan. 

In addition, adjustable rate mortgages have initial rates, also called teaser rates, that are significantly lower than the rates of fixed mortgages.  Teaser rates last for a few months, after which a higher, “normal rate”, commences.  However, this rate is still typically lower than that of a fixed rate mortgage for the first year or two, since even if general interest rates go up, they don’t change enough within that time period to eat away at the interest discount you get for assuming the risk of an ARM.  Therefore an adjustable rate mortgage is almost always a good deal for the first few years.

But, if you hold on to the mortgage beyond that, your major concern is that if the market rates go up, so does the interest you have to pay.  And this leads to higher monthly mortgage bills.

Adjustable rate mortgages are usually good to get during periods of relatively high interest rates, or if you’re reasonably certain you’re not going to hold on to the property you bought for more than about five years.

One advantage of ARMs is that if interest rates go down significantly, you reap the rewards automatically.  Otherwise, with a FRM, you’ll have to go through the motions of shopping for a new mortgage to refinance.  This also protects you should find yourself not able to get a new mortgage due to a change in your financial situation or otherwise.

Another benefit of an ARM is that it can be transferred to a credit worthy buyer.  This loan feature is called assumability, and may come in handy at times when mortgages are hard to come by such as in periods of exceptionally high interest rates.

But not all assumable loans are created equal.  Some lenders put limits on the number of times a loan can be assumed, while others reserve the right to change the loan’s conditions by increasing the interest caps, which limit how high the interest rate can go.  Therefore, it is always best to make sure the ARM you’re getting can be assumed an unlimited number of times without any interest cap adjustments.

The bottom line is that adjustable rate mortgages can at times lead to significant interest savings, but are risky. They are not recommended unless you are absolutely certain you can bare potentially higher mortgage payments if interest rates go up, or are planning on selling the property within a few years.