Adjustable rate mortgages 

People will often consider an adjustable rate mortgage because they sometimes carry a lower interest rate than a standard fixed rate mortgage.  Adjustable rate mortgages carry a certain stigma nowadays because of the sub-prime mortgage mess that involves many short fixed period adjustable rate mortgages.  Contrary to what people might think, an ARM (adjustable rate mortgage) might just be the right loan for you. 

Adjustable rate mortgages are usually referred to as “ARMs” and have an initial fixed rate period followed by an adjustable period.  During the fixed period, the interest rate does not change.  For example, if you took out a 7 Year ARM, your interest rate would be fixed for the first 7 years.  Once the fixed period has expired, your interest rate can change.  It makes sense for someone who is considering living in a home for 5 years or less to take out a 5 year ARM if the interest rate on that ARM is better than a fixed rate mortgage.  Remember, the interest rate is fixed for 5 years so it doesn’t matter if it adjusts after that period.  The person would have moved by the time the interest rate has a chance to adjust. 

Depending on the index your ARM is based on, your interest might increase or decrease from the rate you started with.  What is the index?  The index is a number, or percentage rate that your mortgage interest rate is based on.  For example, an adjustable rate mortgage might be based of the 6 month LIBOR index (London Inter Bank Offered Rate).  This is essentially a percentage that banks borrower money from one another.  Lenders will take the index such as the 6 month LIBOR and add a “margin” to calculate your interest rate after the fixed period expires.  The margin is set by the lender. 

Take a look at the following example to get an idea of how an adjustable rate mortgage works after your fixed period has expired. 

Example: 

Index: 3%

Margin: 4% 

Index + Margin = 7% 

If the index changes, your interest rate will change.  For example, let’s say at the beginning of the year, the above example is true.  However, 12 months later, the index has increased.  Your new rate, if your loan terms allow a subsequent adjustment (explained below) would be as follows: 

Index: 3.55%

Margin: 4% 

Index + Margin = 7.55% 

Your new interest rate would go from 7% to 7.55% because of the increase in the index.  Indexes are constantly changing and could go up or down. 

Adjustable rate mortgages also have adjustment schedules and caps.  If you are considering an adjustable rate mortgage, knowing the adjustment terms is imperative.  A 2/2/6 adjustable rate mortgage on a 5/1 ARM (Fixed for 5 years and can adjust each year thereafter) would mean the following: 

The initial adjustment could increase your rate up to 2%

The subsequent annual adjustment could increase your rate another 2%

The rate adjustment cap over the lifetime of the loan could increase over your initial interest rate on the loan by 6%

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