Adjustable-rate mortgage

Definition

An adjustable-rate mortgage (ARM) is a type of home loan where the interest rate can change periodically based on changes in a corresponding financial index that is associated with the loan. This type of mortgage typically starts with a lower initial interest rate compared to fixed-rate mortgages, but after a set period, the rate adjusts at predetermined intervals, which can lead to fluctuations in monthly payments. Understanding how ARMs relate to different mortgage types, the impact of the loan-to-value ratio, and amortization schedules is crucial for assessing overall loan affordability and risk.

5 Must Know Facts For Your Next Test

1. ARMs typically offer lower initial rates than fixed-rate mortgages, making them attractive to borrowers who may expect to sell or refinance before the first adjustment period.
2. The adjustments in an ARM are based on a specific index, which can include treasury securities or other market rates, meaning monthly payments can vary widely based on market conditions.
3. Most ARMs have a period before the first adjustment, known as the 'initial fixed period', which can range from 1 to 10 years.
4. The loan-to-value ratio (LTV) can impact the terms of an ARM; higher LTVs may lead to higher interest rates due to perceived risk by lenders.
5. Some ARMs include features like interest rate caps and payment caps, which limit how much the interest rate or monthly payment can increase at any adjustment.

Review Questions

• How does an adjustable-rate mortgage differ from a fixed-rate mortgage in terms of risk and cost over time?
  • An adjustable-rate mortgage differs from a fixed-rate mortgage primarily in its initial cost and long-term risk. ARMs usually start with lower interest rates compared to fixed-rate loans, making them more affordable initially. However, since the interest rate on an ARM can change over time based on market conditions, there is an inherent risk that monthly payments could significantly increase after the initial period. This variability can lead to higher overall costs if rates rise substantially.
• What role does the loan-to-value ratio (LTV) play in determining the terms of an adjustable-rate mortgage?
  • The loan-to-value ratio (LTV) plays a crucial role in determining the terms of an adjustable-rate mortgage. A higher LTV indicates that a borrower is financing a larger portion of their home’s value, which increases the lender's risk. Consequently, lenders may impose higher interest rates or stricter terms for ARMs with high LTVs. Conversely, lower LTVs are often associated with better rates and more favorable terms because they represent less risk for lenders.
• Evaluate how changes in market interest rates can affect borrowers with adjustable-rate mortgages compared to those with fixed-rate mortgages during economic fluctuations.
  • Changes in market interest rates significantly impact borrowers with adjustable-rate mortgages differently than those with fixed-rate mortgages during economic fluctuations. For ARM borrowers, rising market rates can lead to increased monthly payments after their initial fixed period ends, making it challenging to budget for future expenses. Conversely, fixed-rate mortgage holders benefit from stable payments regardless of market changes. This stability protects them from rising costs but may prevent them from taking advantage of lower rates available in the market after their loan is locked in.

Related terms

Fixed-rate mortgage: A fixed-rate mortgage is a type of home loan where the interest rate remains constant throughout the life of the loan, providing predictable monthly payments.

Interest Rate Cap: An interest rate cap is a limit on how much the interest rate on an adjustable-rate mortgage can increase at each adjustment period and over the life of the loan.

Amortization Schedule: An amortization schedule is a table that outlines each monthly payment on a loan, showing how much goes toward interest and how much goes toward reducing the principal balance.