Adjustable Mortgage Rates

How Adjustable Mortgage Rates Work

Fixed mortgage rates remain the same through the life of your loan, but adjustable rates fluctuate periodically in relation to different indexes. These fluctuations affect your mortgage payment, which can go up or down according to the interest rate you are paying.

Below is a basic overview of how adjustable mortgage rates work. The overview has been broken into three parts: adjustment periods, indexes, and margins.

Adjustment Periods

With most ARM programs, interest rates and monthly payments may change:

• Every year
• Every three years
• Every five years

However, there is no exact formula that can be applied to every mortgage. Some ARM programs have much more frequent rate and payment changes, and may fluctuate from month to month. When it comes to adjustable mortgage rates, the adjustment period should always be taken into consideration. Changing payments can be inconvenient and confusing, but it can also be beneficial if rates are changing frequently.

Indexes

Lenders use indexes to determine the base rate that is tied to your adjustable mortgage loan. The particular index used varies by lender. Most use the rates associated with Treasury securities, but others use their own cost of funds index. As the rates in these indexes move up, so does your adjustable rate. When they move down, ARMs follow suit.

Margins

After the index rate is determined, lenders also tack on an amount known as the margin. The margin also varies by lender, but averages 2.5 percentage points above the index. For example, let’s say your one year index is 6% and the lender uses a 2% margin. The 6% index + the 2% margin = an adjustable mortgage rate of 8%

Pros and Cons of ARMs

Though there are benefits to getting an adjustable rate mortgage (ARM), there are also drawbacks to choosing this rate type over a fixed rate. It is a good idea to learn as much as you can about these rates before getting your loan. Below is a list of pros and cons in relation to adjustable rates.

Pros

• Adjustable rate mortgages have lower introductory rates than fixed rate mortgages. Borrowers are able to take advantage of low monthly payments at the beginning of their loan term. Money saved can be used for investments, home improvements, and other bills.
• Lower initial payments enable borrowers to take out a larger loan than they may have been able to under normal circumstances.
• Borrowers can take advantage of falling rates without refinancing.

Cons

• Monthly mortgage payments are unpredictable.
• If interest rates rise significantly, homeowners may have a hard time making their monthly payments, and could lose their home if things get very bad for their financial situation.
• Adjustable rate mortgages could cost a borrower more in the long run than fixed rate mortgages.
• Loans with adjustable rates have a higher foreclosure rate than loans with fixed rates.
• Adjustable mortgage rates can be confusing for inexperienced borrowers, making it easy for lenders who aren’t reputable to take advantage of the situation.