A variable-rate mortgage, also known as an adjustable-rate mortgage (ARM) or tracker mortgage, is a home loan with an interest rate that can go either up or down depending on market conditions. These market conditions are based on an underlying index like the federal funds rate, treasury bills, or LIBOR.
How does an adjustable-rate mortgage work?
A variable-rate mortgage can be easier to qualify for than a fixed-rate mortgage. The interest rate, initially, is also much lower than a fixed-rate mortgage. Because of this, you may be able to pay your home loan quicker and save money on interest payments.
In a variable rate mortgage, your payment will stay fixed for the designated term, which is often 5 or 7 years. After that, the interest rate will adjust. If interest rates go down, then your monthly mortgage payment will pay off your principal faster, giving you an advantage. However, if rates go up, your monthly payments will go toward accrued interest and you’ll hardly be able to make a dent in the principal amount.
An adjustable-rate mortgage (ARM) can help you save money if interest rates go down. It is often found that variable-rate mortgages have lower interest and principal payments during the initial fixed interest rate period. After the typical 5 or 7 year phase, the interest rate will change along with the index. A variable-rate mortgage is ideal if you’re a real estate developer or don’t plan to stay in the home very long.
How is the interest rate on an ARM determined?
The interest is determined by the lender. The lender states the index that the ARM would track, then adds a fixed margin (percentage points) to the index rate. The lender's margin doesn’t change, but the index might. For example, in the contract, the lender would state that the ARM is three percentage points above the LIBOR. So, if the LIBOR is at 0.75, then the interest rate is at 3.75.
When does the rate change on an ARM?
The contract determines when the rate will change. The change in an interest rate is called a “reset.”
The periods in which the rate is due for an adjustment could be in months or years. Some ARM contracts have a period in which the interest rate is fixed, before the reset periods. These are called hybrid ARMs. Hybrid ARMs typically come with introductory periods where the rate is fixed for 3,5,7, or even 10 years before it can be adjusted. So, you could end up with a 20-year mortgage that starts with a 5-year fixed interest rate, then a variable rate for 15 years (adjustable annually based on LIBOR movements).
What are interest rate caps, payment caps, and interest rate floors on an ARM?
1. An interest rate cap limits by how much the rate can go up in a period. There are generally two types of interest rate caps:
A periodic adjustment cap limits the interest increase in a period. For example, your ARM could have a 0.5% increase cap per year—no matter how much the underlying index rate has moved up.
A lifetime cap limits the interest rate increase throughout the term of the ARM.
If the index goes above the cap in a period, the rate will increase according to the cap until it equals the index increase. For example, if the cap is 0.5% per year and the index increases by 1.5%, then the rate will increase by 0.5% per year over three years until it matches the 1.5% index increase.
2. A payment cap limits the interest amount that you pay. It can be expressed as a dollar amount (e.g., $100 per period) or as a percentage (e.g., 10% per period).
3. Some ARMs have an interest rate floor, which is the minimum rate that you’ll pay, no matter how much the index declines. This is usually your initial rate or the rate paid during the fixed interest rate period.
The Uncertainty of Interest Rates
Once the loan changes to a variable rate, it’s difficult to know what your payment will be. Adjustable-rate mortgages are a risk because your interest rate may rise after the agreed upon fixed-rate period ends. If you plan to stay in your home for a long time, then the adjustable rate mortgage may not be right for you.
It is possible to loosely estimate how much your variable-rate mortgage may go up after the fixed-rate period ends. It’s all based on the index value and margin value associated with it.
How to Decide if an Adjustable Rate Mortgage is Right for You
The determining factors when deciding between a fixed rate mortgage or a variable-rate mortgage should be what you can afford and how much risk you are willing to take. Variable-rate mortgages (or adjustable-rate mortgages) have a changing nature in their loan, but fixed-rate mortgages have stricter terms and are harder to get approved for.
While the low monthly payments during the initial fixed term may be appealing, it is important to think beyond that 3, 5, 7 or 10 year period. And despite industry predictions, the market is always fluctuating. But now that you understand the inner workings of a variable-rate mortgage, you can make the best decision for you.