Investment Glossary – Adjustable-Rate Mortgage

Unlike many financial terms, the term “adjustable-rate mortgage” actually does a really good job of explaining exactly what it is. It is a mortgage taken out to buy a piece of property with a rate that can adjust over time, rather than staying fixed. See? Wasn’t that easy?

So how does an adjustable-rate mortgage (ARM) actually function? Most adjustable-rate mortgages do still have a fixed-rate period at the start of their term. The most common length of that fixed-rate period is five years, though there are also ARMs with initial fixed-rate periods of three years, seven years, and ten years. Once that fixed-rate period is up, the rate adjusts, typically every year for most ARMs. The way this is denoted in the world of mortgage financing is by using an X/Y notation, with the X representing the length of the initial fixed-rate period, and the Y representing the length of each subsequent adjustment period. So in a 5/1 ARM, your initial fixed-rate period would be five years, with the rate then adjusting every year after that.

This is all well and good, but you may be wondering (or should be wondering), “What does the mortgage rate actually adjust to in those adjustment periods?” In fact, this is a great question, and one of the best ones to ask since this helps to determine how the rate may shift over the course of your loan’s life. There are a whole bunch of different rate indices that ARMs can follow – LIBOR, the Fed Funds rate, one-year Treasury bill rates, the prime rate, and other custom rates that are used by specific banks. It’s not possible to list them all here without making this really boring and long, so we’re not going to try to. But the specific index your mortgage is tied to is going to be a major determining factor for how your rate moves after the fixed-rate period.

The other piece that plays into this is a term called the margin. The margin on an ARM is the amount that the lender adds on top of the index rate. So for example, if you had a mortgage indexed to the one-year Treasury bill rate plus a margin of 2%, and you were through your fixed-rate period and into the adjustable-rate portion of your loan, your rate for that year would be whatever that one-year Treasury bill rate is on the date of the adjustment, plus 2%. That process would happen again with that index and the margin the following year as well, until the loan is paid off or you refinance out of it. But the way to calculate your rate for the upcoming year is to take the index rate, add the margin to it, and that’s what your new rate will be.

So what effect does the rate adjustment actually have on your mortgage?

Well, any time there is a change in the rate, you’ll see a change in the amortization, meaning that if the rate goes down, your monthly payment may go down, but if the rate goes up, your monthly payment may rise, perhaps significantly. This is one of the key concepts to focus on and understand when it comes to ARMs, as the threat of an increased monthly payment is one that you need to understand, both in term of how high that payment can go and how often it can adjust. Stress-testing your income versus the maximum monthly payment is critical, as life circumstances such as job changes and other expenses may prevent you from refinancing out of an ARM in the event the rate rises.

Most ARMs issued today have rate caps that prevent your rate from getting too high, either across the life of the loan, or from adjusting too significantly in any one year. Make sure you are clear on any yearly adjustment caps, as well as lifetime caps on rates, because you want to be aware of what can happen to your mortgage if rates rise significantly. This was a widespread problem in the buildup to the 2008 financial crisis, in that many borrowers ended up defaulting in 2006-2008 as rates rose since they could not afford the higher payments on the ARMs.

So with all that being said, why the heck would anyone choose an ARM instead of a fixed-rate mortgage? The reason is that the initial fixed-rate period on an ARM often has a lower rate than conventional 30-year fixed-rate mortgages, meaning that it can help with the affordability of a home as someone is looking at properties. Other than that, there often isn’t a meaningful reason why someone would choose an ARM over a fixed-rate mortgage. ARMs can be a valuable tool if used properly, but beware of the potential increases in your monthly principal and interest payments, and make sure you understand the ins and outs of the loan you are signing before you make any final decisions.

We have a guide available that can help you work through the ins and outs of the home-buying process. Click here to download it for free.