An adjustable rate mortgage or variable rate mortgage is a loan secured on a property (house) whose interest rate and so monthly repayment vary over time. Other forms of mortgage loan include interest only mortgage, fixed rate mortgage, Negative amortization mortgage, discounted rate mortgage and balloon payment mortgage. Adjustable rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls and loses out if interest rates rise.

Variable rate mortgages are the most common form of loan for house purchase in the United Kingdom but are unpopular in some other countries. Variable rate mortgages are very common in Australia and New Zealand. For those who plan to move within a relatively short period of time (three to seven years), they are attractive because they often include a lower, fixed rate of interest for the first three, five, or seven years of the loan, after which the interest rate fluctuates.

Adjustable rate mortgages, like other types of mortgage, may offer the ability to repay principal (or capital) early without penalty. Early payments of part of the principal will reduce the total cost of the loan (total interest paid), and will shorten the amount of time needed to pay off the loan. Early payoff of the entire loan amount (refinancing) is often done when interest rates drop significantly.

Adjustable rate mortgages are sometimes sold to unsophisticated consumers who are unlikely to be able to repay the loan should interest rates rise, which they often do. In the United States, extreme cases are characterized by the Consumer Federation of America as predatory loans. Protections against interest rate rises include (a) a possible initial period with a fixed rate (which gives the borrower a chance to increase his/her annual earnings before payments rise); (b) a maximum (cap) that interest rates can rise in any year (if there is a cap, it must be specified in the loan document); and (c) a maximum (cap) that interest rates can rise over the life of the mortage (this also must be specified in the loan document).

The Hybrid ARM

What is the difference between a hybrid and a traditional ARM

THE dominant loan product in today's marketplace. They are often packaged as the 5/1 ARM or the 2/28 ARM (most popular products). The loan is a "Hybrid" because a true ARM adjusts for the same periods for the life of the loan, ie. a 6 Month ARM is fixed for the first six months and adjusts every six months afterwards. The 2/28 "Hybrid ARM" is a 6 month ARM that the borrower has purchased a "Rate Lock" or introductory rate for the first 2 years (this is also done in 3,5,7 year fixed periods), and then the loan becomes a 6 month ARM thereafter, rather than a loan that does only adjust every 2 years.

The benefits

This loan product has actually lowered the costs of borrowing in the early years of loans, but certainly is a source of continuing refinance business to the Mortgage industry. They let borrowers take advantage of special pricing, by saving money on payments a) when the borrower's salary is rising such as for young professionals or b) when the borrower knows they are going to move up quickly from one home to another.

The risks

If a borrower is inconsistent in their on time payment history, afflicted by tragedy which causes a credit problem, or keeps insufficient funds in reserve (the payment savings from the lower rate for example), as referenced above, the rates in Hybrid ARMs will certainly rise, and with insufficient credit and income, the borrower may be forced to trade equity for time, and in some markets, not as advantageously as today.

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Terminology

• Fully Indexed Rate - The price of the ARM as calculated by adding Index + Margin = Fully Indexed Rate. This is the interest rate your loan would be at without a Start Rate (the introductory special rate for the initial fixed period). This means, your loan would be higher today if it was adjusting, typically, 1-3% higher than the introductory rate. Calculating this is IMPORTANT for ARM buyers, since it helps you predict the future interest rate of your loan.

• Margin - This refers to the banks profit margin above the value of the financial index. The bank seeks to make a profit above the costs of inflation. The index is a measure of the cost of funds as measured by inflation.

• Index - A publicly published financial index such as LIBOR (usually 1 month, 6 month or 12 month), 11th District Cost of Funds Index, MTA, etc.

• Start Rate - The introductory rate provided to purchasers of ARM loans for the initial fixed interest period. The difference between the "Start Rate" of an ARM and the rate of a fixed terms loan is that the "Start Rate".

• Period - This is the frequency of adjustments, the longer the rate remains fixed, the better the loan is for the borrower. Typically, the shorter this is the lower the rate, since there are more opportunities to adjust upwards.

• Floor - A clause that sets the minimum rate for the interest rate of an ARM loan. Most loans come with a Start Rate = Floor feature, but this is primarily for Non-Conforming (aka Sub-Prime or Program Lending) loan products. This prevents an ARM loan from ever adjusting lower. An "A Paper" loan typically has either no Floor or 2% below start.

• Payment Shock - Industry term to describe the severe (unexpected or planned for by borrower) upward movement of mortgage loan interest rates and its effect on borrowers. Sadly, for those that do not read this wiki entry or who do read it but cannot understand its contents, they may experience it, or spend too much of their incomes to borrow on fixed terms only. See Caps below

• Cap - Any clause that sets a maximum change for the interest rate of an ARM loan.

Understanding Caps

• "The Caps" - In industry slang, there you could ask for the Caps of a loan, and if your broker or loan officer is intelligent enough to read the rate sheets they are quoting from, it is ALWAYS displayed and available. This is basic stuff, the ABC's of mortgage lending, if you're working with someone that can't or won't explain this to you, go elsewhere.

• What's better? - The lower these numbers are, the better for you, especially, the first number.

Examples: 2/2/5 ; 5/2/5 ; 2/1/6 ; 3/1/6 ; 2/4 ; 1/1/5 .

The first number is the initial change cap, the second is the periodic cap, the last is the life cap. When only two values are given, this always means the initial change cap and periodic cap are the same. The longer the initial fixed period, typically, the higher the caps are given.

• Initial Change Cap - ARM loans have a specified maximum first adjustment that is typically higher than allowed on subsequent changes.

• Periodic Change Cap - The maximum interest rate adjustment for every subsequent periodic adjustment.

• Life Cap (Ceiling) - The maximum upwards adjustment of an ARM loan. Typically on first mortgages no more than 6%.

Crucial Information About Caps

Loan caps provide payment protection against payment shock. Most First Mortgage loans have a 5% or 6% Life Cap. Higher risk products, such as Monthly Adjustable loans with Negative amortization and Home Equity Lines of Credit aka HELOC have different ways of structuring the Cap than a typical First Lien Mortgage.

• First Lien Caps with no Negative amortization

Most First Mortgage loans have a 5% or 6% Life Cap. If the adjustment period is 6 months or 1 year ( the two most common periods on the market), then it takes anywhere from 2-4 maxiumum upward adjustments to reach this cap

• Negative amortization ARM caps

See the complete article for the type of ARM that NegAM loans are by nature. Most of them are Monthly Adjustable ARMs and the life cap or ceiling is simply expressed as a maximum rate, usually 9.95% or 10.95% these days. Beware though, some of these loans have 14-16% ceilings, you have to ask . . . . The fully indexed rate is always listed on the statement, but borrowers are shielded from the full effect of rate increases by the minimum payment, until the loan is recast

• Home Equity Lines of Credit HELOC

Since HELOCs are intended by banks to primarily sit in second lien position, they normally are only capped by the maximum interest rate allowed by law in the state they are issued in! In Florida, for example, this is 18% ! Wow!

Sadly, most people do not take the time to learn about their ARM product, and some people even take these loans out as their First Lien loan, putting their house in jeopardy of foreclosure if there is an inflationary market.

External links

• U.S. Federal Reserve Consumer Handbook on Adjustable Rate Mortgages
• US historical mortgage rates, 1977 - present