Adjustable Rate Mortgage Loan

What is an adjustable-rate mortgage loan?

A.K.A. ARM, floating rate mortgage or variable-rate mortgage. It is a type mortgage is a loan where the interest rate varies according to an external benchmark or index. This means that the internet rate can go up or down periodically - sometimes it stays the same for a period of time. However, it includes an initial period where borrowers pay a typically fixed interest rate for a set period. When this period ends, your monthly payments might change based on the market forces index. This is determined by the lender, which adds on a margin to the index.

Even though interest rates can be expected to go up or down, they are unpredictable. These recent decades, we have been experiencing a trend up and down over multiple-year cycles. In the US, these past few years they have been in an upward interest rate.

For example, a 2/28 ARM has an initial interest rate that is fixed for two years and then a floating rate for the remaining 28 years of the mortgage.

How ARM loans work?

A mortgage loan with a variable interest rate can rise or fall whenever the lender decides to. This usually depends on different factors such as their funding costs - the source where they get money to finance its customers - or changes to the official cash rate.

But it is important to mention that variable rate mortgages do not change all the time - it may only do it a few times during the year. It will vary when your lender evaluates that the current economic conditions deserve it. And while a rate increase means your repayments rise, a rate drop means your repayments get cheaper.

The good thing is that these mortgages are more flexible than fixed ones. They also tend to be cheaper because rates are lower and fees are fewer.

What is the determining factor of these “economic conditions”? Most adjustable-rate mortgage rates are tied to the performance of one of the many indexes in the USA.

Some common mortgage indexes include: the prime lending rate, the one-year constant maturity treasury (CMT) value, the one-month, six-month and 12-month LIBORs, as well as the MTA index, which is a 12-month moving average of the one-year CMT index.

Types of ARM

There are some specific types of ARM and they are:

• ► Standard variable rate mortgages. This is the most common one. The lender is in charge to raise or lower the rate at any amount and any time - when they consider it is necessary. 

• ► Hybrid ARMs. This is a mixture loan between a fixed- rate and an adjustable-rate mortgage. This means that the interest rate will be fixed for an initial period, and then it will adjust annually according to the index. 

• ► Interest-only (I-O) ARMs. These mortgages allow you to pay only interests for a set period of time - usually 3-10 years. This is suitable for people that expect to get better financially in the next few years but can only make smaller payments during an initial period. After this time, the payments will increase and adjust to the market.

• ► Discount rate mortgages. This is another type of variable rate mortgage in which the mortgage lender gives you a discount on its standard variable rate for either a set period or for the entire term of the mortgage.

Since ARMs are designed to be flexible, there are more specialized mortgages that can fit your needs. In case you are looking for something more specific, we recommend you to contact a mortgage broker to get some guidance on the topic.

Pros and Cons of ARM loans