Adjustable Rate Mortgage
a type of mortgage where the interest rate changes as time pass.
Adjustable Rate Mortgage Details
To set the interest rate on an Adjustable Rate Mortgage, the bank takes a look at some financial indexes such as LIBOR to set their base interest rate. London Inter-bank Offered Rate (LIBOR) gives an average of the interest rates that banks are lending to each other. Sometimes, the financial index can significantly go up or down unexpectedly. The interest rate ceiling restricts the interest rate from going higher than a certain point, which protects the borrower (the customer) from sharp climbs on the financial index. The interest rate floor restricts the interest rate from falling below a certain point, which protects the lender (the bank) from losing profit derived from the margin.
After consulting these indexes, the bank put a margin, which adds an additional rate to the mortgage. The margin acts as a premium or a service fee for the bank. The bank could also take into account the customer’s credit score as a factor for the additional rate. The composite rate is the combination of the financial index rate and the margin rate.
The time interval at which the interest rate changes also varies. Some banks have a 1-year reset policy, while some have half-year intervals or even three-month intervals. The longer the interval, the more interest rate the lender keeps (the bank). The shorter the interval, the more interest rate is passed to the borrower (the customers).
Example of an Adjustable Rate Mortgage
Let’s say you’re going to buy a car for $50,000 and you want to use an adjustable rate mortgage to cover the cost. A typical adjustable rate mortgage is a 3/1 ARM with 10 years duration and a 4% initial interest rate. The interest interval is one year, the interest rate ceiling is 12%, and the interest is expected to increase by 0.25% each year.
You can change the duration of the mortgage, ranging from 1 year to 40 years; however, the longer the duration, the bigger the risk you’ll carry. The initial interest rate can also vary depending on the banks’ preference. A lower interest rate will attract more customers, but the bank will suffer more risk of losing profits. Please keep in mind that the interest rate could change more or less than 0.25% each year in a real-world scenario, but it won’t exceed the interest rate ceiling, which is 12%.
A 3/1 ARM means that your mortgage is bundled with a fixed-rate mortgage. For 3 years, your interest rate will be fixed at 4% (the initial interest rate). Your first monthly payment is equal to $506, while your first yearly payment is equal to $6,074. After 3 years, the interest rate will begin to climb from 4.25% (at 36th month of payment) to 5.75% (at 108th month of payment), assuming the index follows the expected interest rate increase. The total money you’re going to pay over 10 years of 3/1 ARM is $61,794, with $11,794 as the interest cost.
Significance of Adjustable Rate Mortgage
Mortgages aren’t one size fits all; every person has different priorities and capabilities. The adjustable rate mortgage offers a nice alternative to the traditional fixed-rate mortgage to cater to more customers and spicing up the competition. The adjustable rate mortgage offers a set of nice perks such as lower interest rates, cheaper monthly payments, and high flexibility.
There’s one aspect that’s more important than others: risk. Because adjustable rate mortgage’s interest rate is tied to the condition of the market via financial indexes, your interest rate could significantly rise if the market condition worsens. However, like a double-edged sword, if the market condition gets better, your interest rate may lower, which makes your payments much more manageable. The key to managing an adjustable rate mortgage is to know the state of the current market and how long it will stay in your favor.
The second key to managing an adjustable rate mortgage is determining mortgage duration and interest cap. The example above is an optimal case for an adjustable rate mortgage; a short-duration mortgage that limits the risk of the increasing interest rate, preventing you from paying more than you can afford. You can get a long-duration adjustable rate mortgage only if you can pay it in a short amount of time, as in paying years’ worth of payments in mere months. Find banks that offer the lowest interest cap, since it helps to prevent the interest rate from going wild, devouring your finances.
Types of Adjustable Rate Mortgages
The first type is a hybrid ARM, which is an adjustable rate mortgage bundled with a fixed rate mortgage. The most common types of hybrid ARM are 3/1 ARM, 5/1 ARM, 7/1 ARM, and 10/1 ARM. A 10/1 ARM means that for the first 10 years, your interest rate is fixed at a certain percentage. After 10 years, the interest rate will change depending on the financial index and the bank’s margin. The “1” in 10/1 ARM refers to the time interval in which the interest rate will be reset, which is 1 year.
The second type is the option adjustable rate mortgage. In an option ARM, the borrower has a few options to choose from on how they’ll pay the mortgage. The options are: minimum payment, interest-only payment, 15-year fully amortized payment, or 30-year fully amortized payment. The 15-year and 30-year fully amortized payment is like a conventional loan schedule where the borrower pays a certain amount of money that will fully pay the loan after 15 or 30 years.
Meanwhile, the minimum payment and interest-only payment may result in cheap payments during the first few periods. But once the period expires, borrowers could be exposed to a higher interest rate as a result of the low initial interest rate. It’s suitable for people who have little to no money at the start of the loan but will get more money as time passes, like investors.