Adjustable-rate mortgage


A variable-rate mortgage, adjustable-rate mortgage, or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets. The loan may be offered at the lender's standard variable rate/base rate. There may be a direct and legally defined link to the underlying index, but where the lender offers no specific link to the underlying market or index, the rate can be changed at the lender's discretion. The term "variable-rate mortgage" is most common outside the United States, whilst in the United States, "adjustable-rate mortgage" is most common, and implies a mortgage regulated by the Federal government, with caps on charges. In many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages.
Among the most common indices are the rates on 1-year constant-maturity Treasury securities, the cost of funds index, and the London Interbank Offered Rate. A few lenders use their own cost of funds as an index, rather than using other indices. This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate. This is distinct from the graduated payment mortgage, which offers changing payment amounts but a fixed interest rate. Other forms of mortgage loan include the interest-only mortgage, the fixed-rate mortgage, the negative amortization mortgage, and the 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 but loses if the interest rate increases. The borrower also benefits from reduced margins to the underlying cost of borrowing compared to fixed or capped rate mortgages.
In contrast to fixed-rate mortgages, adjustable-rate mortgages are unaffected by inflation risk, but they are exposed to the risk that real interest rates will change. Adjustable-rate mortgages usually charge lower interest rates than those with fixed rates. According to scholars, "borrowers should generally prefer adjustable-rate over fixed-rate mortgages, unless interest rates are low."

Characteristics

Index

In some countries, banks may publish a prime lending rate which is used as the index. The index may be applied in one of three ways: directly, on a rate plus margin basis, or based on index movement.
A directly applied index means that the interest rate changes exactly with the index. In other words, the interest rate on the note exactly equals the index. Of the above indices, only the contract rate index is applied directly.
To apply an index on a rate plus margin basis means that the interest rate will equal the underlying index plus a margin. The margin is specified in the note and remains fixed over the life of the loan. For example, a mortgage interest rate may be specified in the note as being LIBOR plus 2%, with 2% being the margin and LIBOR being the index.
The final way to apply an index is on a movement basis. In this scheme, the mortgage is originated at an agreed upon rate, then adjusted based on the movement of the index. Unlike direct or index plus margin, the initial rate is not explicitly tied to any index; the adjustments are tied to an index.

Basic features

The most important basic features of ARMs are:
  1. Initial interest rate. This is the beginning interest rate on an ARM.
  2. The adjustment period. This is the length of time that the interest rate or loan period on an ARM is scheduled to remain unchanged. The rate is reset at the end of this period, and the monthly loan payment is recalculated.
  3. The index rate. Most lenders tie ARM interest rates changes to changes in an index rate. Lenders base ARM rates on a variety of indices, the most common being rates on one-, three-, or five-year Treasury securities. Another common index is the national or regional average cost of funds to savings and loan associations.
  4. The margin. This is the percentage points that lenders add to the index rate to determine the ARM's interest rate.
  5. Interest rate caps. These are the limits on how much the interest rate or the monthly payment can be changed at the end of each adjustment period or over the life of the loan.
  6. Initial discounts. These are interest rate concessions, often used as promotional aids, offered the first year or more of a loan. They reduce the interest rate below the prevailing rate.
  7. Negative amortization. This means the mortgage balance is increasing. This occurs whenever the monthly mortgage payments are not large enough to pay all the interest due on the mortgage. This may be caused when the payment cap contained in the ARM is low enough such that the principal plus interest payment is greater than the payment cap.
  8. Conversion. The agreement with the lender may have a clause that allows the buyer to convert the ARM to a fixed-rate mortgage at designated times.
  9. Prepayment. Some agreements may require the buyer to pay special fees or penalties if the ARM is paid off early. Prepayment terms are sometimes negotiable.
The choice of a home mortgage loan is complicated and time consuming. As a help to the buyer, the Federal Reserve Board and the Federal Home Loan Bank Board have prepared a mortgage checklist.

Caps

Any mortgage where payments made by the borrower may increase over time brings with it the risk of financial hardship to the borrower. To limit this risk, limitations on charges—known as caps in the industry—are a common feature of adjustable rate mortgages. Caps typically apply to three characteristics of the mortgage:
  • frequency of the interest rate change
  • periodic change in interest rate
  • total change in interest rate over the life of the loan, sometimes called life cap
For example, a given ARM might have the following types of interest rate adjustment caps:
  • interest adjustments made every six months, typically 1% per adjustment, 2% total per year
  • interest adjustments made only once a year, typically 2% maximum
  • interest rate may adjust no more than 1% in a year
Mortgage payment adjustment caps:
  • maximum mortgage payment adjustments, usually 7.5% annually on pay-option/negative amortization loans
Life of loan interest rate adjustment caps:
  • total interest rate adjustment limited to 5% or 6% for the life of the loan.
Caps on the periodic change in interest rate may be broken up into one limit on the first periodic change and a separate limit on subsequent periodic change, for example 5% on the initial adjustment and 2% on subsequent adjustments.
Although uncommon, a cap may limit the maximum monthly payment in absolute terms, rather than in relative terms.
ARMs that allow negative amortization will typically have payment adjustments that occur less frequently than the interest rate adjustment. For example, the interest rate may be adjusted every month, but the payment amount only once every 12 months.
Cap structure is sometimes expressed as initial adjustment cap / subsequent adjustment cap / life cap, for example 2/2/5 for a loan with a 2% cap on the initial adjustment, a 2% cap on subsequent adjustments, and a 5% cap on total interest rate adjustments. When only two values are given, this indicates that the initial change cap and periodic cap are the same. For example, a 2/2/5 cap structure may sometimes be written simply 2/5.

Motives

ARMs generally permit borrowers to lower their initial payments if they are willing to assume the risk of interest rate changes. There is evidence that consumers tend to prefer contracts with the lowest initial rates such as in the UK, where consumers tend to focus on immediate monthly mortgage costs. Decisions of consumers may also be affected by the advice that they get, and much of the advice is provided by lenders who may prefer ARMs because of financial market structures.
In many countries, banks or similar financial institutions are the primary originators of mortgages. For banks that are funded from customer deposits, the customer deposits typically have much shorter terms than residential mortgages. If a bank offered large volumes of mortgages at fixed rates but derived most of its funding from deposits, it would have an asset–liability mismatch because of interest rate risk. It would then be running the risk that the interest income from its mortgage portfolio would be less than it needed to pay its depositors. In the United States, some argue that the savings and loan crisis was in part caused by the problem: the savings and loans companies had short-term deposits and long-term, fixed-rate mortgages and so were caught when Paul Volcker raised interest rates in the early 1980s. Therefore, banks and other financial institutions offer adjustable rate mortgages because it reduces risk and matches their sources of funding.
Banking regulators pay close attention to asset-liability mismatches to avoid such problems, and they place tight restrictions on the amount of long-term fixed-rate mortgages that banks may hold in relation to their other assets. To reduce the risk, many mortgage originators sell many of their mortgages, particularly the mortgages with fixed rates.
For the borrower, adjustable rate mortgages may be less expensive but at the price of bearing higher risk. Many ARMs have "teaser periods", which are relatively short initial fixed-rate periods when the ARM bears an interest rate that is substantially below the "fully indexed" rate. The teaser period may induce some borrowers to view an ARM as more of a bargain than it really represents. A low teaser rate predisposes an ARM to sustain above-average payment increases.