Adjustable-Rate Mortgages

Definition

An adjustable-rate mortgage (ARM) is a type of mortgage loan where the interest rate charged on the outstanding balance varies throughout the life of the loan. The interest rate is periodically adjusted based on a benchmark or index, which can result in changes to the monthly payment amount over time.

5 Must Know Facts For Your Next Test

1. Adjustable-rate mortgages typically have an initial fixed-rate period, after which the rate adjusts periodically based on the chosen index and margin.
2. The monthly payments on an ARM can increase or decrease over time as the interest rate changes, which impacts the timing and amount of cash flows for the borrower.
3. ARMs are often associated with higher interest rate risk compared to fixed-rate mortgages, as the borrower is exposed to fluctuations in market interest rates.
4. Lenders may offer ARMs with various adjustment periods, such as annually, semi-annually, or even monthly, which can affect the frequency of payment changes.
5. Borrowers may choose an ARM if they anticipate a higher income in the future or plan to sell the property before the initial fixed-rate period ends.

Review Questions

• Explain how the timing of cash flows is affected by an adjustable-rate mortgage.
  • The timing of cash flows for an adjustable-rate mortgage can vary significantly over the life of the loan due to the periodic adjustments in the interest rate. During the initial fixed-rate period, the borrower's monthly payments remain constant. However, after the fixed-rate period ends, the payments can increase or decrease depending on changes in the underlying index and margin. This can lead to unpredictable cash flow patterns for the borrower, as the timing and amount of future payments become less certain compared to a fixed-rate mortgage.
• Describe the interest rate risk associated with adjustable-rate mortgages and how it relates to the concept of interest rate risk.
  • Adjustable-rate mortgages expose the borrower to a higher degree of interest rate risk compared to fixed-rate mortgages. With an ARM, the interest rate can fluctuate over time, which means the borrower's monthly payments may increase or decrease based on changes in the underlying index and margin. This interest rate risk can have a significant impact on the borrower's financial planning and budgeting, as they may need to adjust their spending or refinance the loan to manage the changes in their monthly obligations. The interest rate risk associated with ARMs is a key consideration within the broader context of interest rate risk, which encompasses the potential for changes in market interest rates to affect the value of financial assets and liabilities.
• Evaluate the factors a borrower should consider when deciding between an adjustable-rate mortgage and a fixed-rate mortgage, particularly in the context of their financial situation and long-term plans.
  • When deciding between an adjustable-rate mortgage and a fixed-rate mortgage, a borrower should carefully evaluate their financial situation and long-term plans. If the borrower anticipates a higher income in the future or plans to sell the property before the initial fixed-rate period ends, an ARM may be a suitable option as it can provide lower initial payments. However, the borrower must also consider the potential for increased interest rate risk and the possibility of higher future payments if market rates rise. Conversely, a fixed-rate mortgage may be the better choice for borrowers who value payment stability and predictability, or those who plan to remain in the property for an extended period and want to lock in a fixed interest rate. Ultimately, the decision should be based on the borrower's risk tolerance, financial goals, and expected time horizon for the mortgage.

Related terms

Fixed-Rate Mortgage: A mortgage loan where the interest rate remains the same throughout the entire loan term, resulting in consistent monthly payments.

Index: The benchmark or reference rate used to determine the adjustable interest rate on an ARM, such as the LIBOR or the Prime Rate.

Margin: The fixed percentage added to the index to determine the actual interest rate on an ARM.