Adjustable Rate Mortgages (ARM)

What they are and what it means to you

Inflation and unsettled interest rates of the 1970s lead to the development of alternative methods of financing mortgage loans. These alternative repayment plans were viewed as a means of assisting borrowers in qualifying for a loan larger than they would have otherwise qualified for using a standard, fixed-interest rate product. Alternative loan products allowed many people to purchase a home at a time when fixed-interest products were at a historically high rate. The most widely used alternative loan was an ARM during that time.

A major risk undertaken by lenders on a long-term mortgage is the risk that rates will increase in the future. For example, if a lender is holding a portfolio of loans at rates in the 6% range, the portfolio loses considerable value if rates move significantly higher in the future. Therefore, an ARM is preferred by lenders because it limits the lender’s exposure to rising interest rates. Since the 1970s, lenders have often encouraged borrowers to consider an ARM program by offering initial interest rates that are lower than traditional fixed-rate loans. In fact, the lender is offering a lower initial rate in exchange for the borrower taking on more of the lender’s risk of higher interest rate in the future.

In an ARM, the borrower obtains a loan for a certain term, usually 15 or 30 years. The loan is funded at an initial rate of interest that will remain fixed for a period of time. The period will vary depending on the loan product. Rate change in an ARM is determined by increase or decrease in a fund’s index that is not under the control of the lender.

The index is what the lender uses as an instrument for measuring changes in interest rates. It is the lender’s barometer of change in interest rates. One of the major protections offered to the borrower who accepts an ARM loan is that any change in the rate of interest must be tied to the change in the index. As the index rate moves up, so does the interest rate charged by the lender to the consumer resulting in a higher monthly payment to the borrower. As the index rate moves down, the interest rate charged by the lender to the consumer goes down resulting in lower monthly payment to the borrower.

Advantages of Adjustable Rate Mortgage Loans:

  • Lower interest rate
  • Higher amounts for the loan
  • Falling rates

Disadvantages of Adjustable Rate Mortgage Loans:

  • Early refinancing
  • Unpredictable home mortgage payments