Adjustable-Rate Mortgage – Definition

Cite this article as:"Adjustable-Rate Mortgage – Definition," in The Business Professor, updated February 15, 2019, last accessed October 20, 2020, https://thebusinessprofessor.com/lesson/adjustable-rate-mortgage-definition/.

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Adjusted-Rate Mortgage Definition

This is a form of mortgage where the interest rate on the outstanding balance is not constant but varies throughout the life of the loan. The initial rate is first fixed for a period of time, and then it resets periodically after a month or a year. These interest rates adjust with London Interbank Offered Rate (LIBOR) or the treasury bills.

A Little More on What is an Adjustable-Rate Mortgage – ARM

There are a variety of options when considering to purchase a mortgage. This is because the mortgage structures vary and various factors such as the transaction amounts, the loan maturities, interest rates, and many others can be negotiated. ARM is the most popular, and it can adjust interest rate mortgages.

In this type of loan, if the interest rates start low, they are then adjusted over a period based on the rates like the LIBOR. The reason why the interest rates are adjusted is because the current interest rates increase the margin. ARM is handy in some situations and ineffective in others leading to foreclosure. This means that those who want to buy mortgages must understand their characteristics and consider the long-term risks involved.

The primary considerations for the ARM include the frequency of interest rate adjustments, fixed interest rate period, the index basis and finally whether a limit exists for the interest rates or payment.

Fixed Interest period of the ARM

Hybrid ARM is the most common adjustable-rate mortgage, and it guarantees that specific rates remain fixed for a certain period. The initial rate usually is lower when compared to that of a 30-year fixed traditional loan. An ARM 3/1, for example, has a fixed rate of three years although the fixed term does vary significantly from about a month to ten years being subject to the restrictions allowed by the lender.

In a situation where one frequently relocates after a few years, ARM is very useful in ensuring that less interest on a 30-year interest on a standard fixed loan. This period also provides one with an opportunity to assess whether to refinance or not depending on the direction of the interest rates.

The interest rate of the mortgage is calculated by adjusting it based on the specific interest rate index and the lender’s credit.

Interest rate index

On the documentation of each ARM, there is an index on the basis of the interest rate adjustment. This index indicates the current interest rates. These rates rise and fall following the interest rates. Even if each follows the overall trend, sometimes it’s impossible to track the average interest rate accurately.

Margin

The margin is used to determine the percentage of the new interest rates. If the average of the index is 4% and the profit margin is set at 3%, then the interest rate is adjusted to 7%. The index together with the margin are known as fully indexed interest rates. If one has better credit, the margin goes low. Once the ARM is adjusted as a result of the margin, the interest rate drops to maintain an equal or lower interest rate.

In the comparison of ARM, the one having the largest margin is not always the loser since one may be using an index that is lower or less volatile. To understand the location of the future interest rates, one has to understand the recent position of the index.

How often is interest rate adjusted in ARM?

It is essential for one to know the frequency of future changes once the interest rate is adjusted. This is because it helps one to budget and know when the need to refinance arises. For example, in a hybrid ARM 3/1, it means that the rate will be adjusted for the first time in three years and then the second number suggests that it will be modified every year after that.

Is the interest rate or payment limited in ARMs?

Limited interest rates or payment means that they can only be increased at a certain amount and after a certain period. Several restrictions prevent short-term payments or interest rates from increasing suddenly.

Interest rate limit

There are two types of marginal interest rates:

  •  The permanent limits which keep the interest rates above a specific rate.
  • Periodic corrections which over time prevent the acceleration for too long over a period of time.

Even if the index has not changed but is still higher than the highest amount of the year, the interest rates for the next year may continue to adjust. Suppose the index had grown by 1.5% in the previous year but is expected to stay at this level for the next few years. In the first year, the rate will increase by 0.5% and then it will continue to increase by this amount until it coincides with the index plus the margin.

Interest rate floor

Various ARMs have a set minimum interest rate where the interest rates below it is unlikely to be met even when the interest rates fall sharply. The ‘lowest level’ can be an effective interest rate for a fixed period or the first correct interest rate.

Payment limit

This limit prevents the payment from becoming too high at any given time. The limit might be in US dollars or a percentage. The new payment, however, is compared to the previous payment and not the original one.

Despite the interest rate limits the payment limits are still valid. This means that even if the interest rates significantly increase, it is not guaranteed that the payment will also increase. However, these percentages are added to the mortgage balance to create what is called a negative depreciation.

In the instance where the interest rates rise, and the payment fails, the credit balance does increase instead of decreasing every month. Some ARMs contain a clause that eliminates the payment limit should the current loan balance exceed a certain amount of a particular loan. This increases payments.

Different ARM Types

There other types of ARM which are less common other than mixing ARM.

ARM of Interest

It is only with this interest-based ARM where someone can pay interest every month without paying money. It ensures that the payment is reduced although it does not help someone save money or get closer to home. It is usually utilized by investors who don’t plan on staying home for an extended period or pay for it for several years.

Since mortgage loans used only for interest eventually recover and pay back the principal, taking such a loan is risky. When it happens, one notes that the payment significantly increases. Before getting such a loan, a person must find out when and how it qualifies for a full write-off.

Negative amortization of the mortgage

This a term used to describe a mortgage that is paid less than the monthly percentage. In this mortgage, the loan balance keeps increasing since the unpaid interest gets added to the loan balance. If the loan balance becomes too high, the mortgage is restored, and the payment increases significantly.

A select payment mortgage

It is also called a mortgage for a payment option, and it’s a new type of loan that is very suitable for problems. This loan offers more payment options per month and ensures that one is not on default if he pays the least minimum payment. They are popular during rising house prices since people can enter more houses with less money.

It gives people the option of paying all the interest together with a few base interests, just the interest or less than earned interest in the current month. Since most people choose the lowest payment, it means that over time, the unpaid interest leads to a significant increase in the loan balance. After the balance reaches a specific point, the mortgage resumes and the payment increases significantly.

This mortgage loan is usually an excellent tool for investors but not to for those who want to be at home. The choice of a mortgage is generally sold to people who don’t know how to pay the minimum payment to increase the loan balance.

Advantages and disadvantages of ARM

ARM has a few advantages as well as disadvantages.

Advantages

  • ARMs are cheaper compared to fixed-rate mortgages since they have a lower closing cost.
  • Lower fixed rate. The ARMs’ rates are usually permanently lower than the fixed rate.
  • Generous fixed interest period. A type of ARM like the 5/1 gives someone sufficient time for selling or refinancing the house without changing the original interest rate. This means that one can save money at lower cost if the interest rate environment stays low
  • It can help someone obtain a bigger house by applying for a bigger loan since the down payment is lower than a fixed rate mortgage rate. It is relatively easy to qualify and cheap.

Disadvantages

  • The interest rate is not consistent, and this affects the budget especially if it gets adjusted once a month.
  • Interest rates rise since they usually are artificially low for a fixed period. When they rise, the interest rates may reach the highest amounts, and this can lead to negative depreciation.
  • Although the interest rates are usually lower than the 30-year fixed mortgage rate, when they rise before refinancing, they reduce the interest rate for 30 years.
  • There is a likelihood of there being hidden problems. Since mortgage lenders are not the riskiest group, they tend to abuse some mortgages like the ARM. One must understand the rules to make sure there does not exist any exclusions in them.

Floating rate mortgages have risen in popularity in recent years mainly because they have lower costs and interest rates. However, they are also abused. Before choosing a mortgage like ARM, one needs first to consider his situation and intent. One must also take time to understand and compare the mortgages and remember the features that are most important.

References for Adjustable Rate Mortgage

Academic Research for Adjustable Rate Mortgage

  • A dynamic analysis of fixed-and adjustable-rate mortgage terminations, Calhoun, C. A., & Deng, Y. (2002). In New Directions in Real Estate Finance and Investment (pp. 9-33). Springer, Boston, MA. This paper gives a comparison of loan-level statistical models for fixed and adjustable-rate mortgages. It also investigates whether the effects of estimated option values for prepayment and default have any comparison to both fixed-rate mortgages and ARM loans and if they provide additional empirical support for the basic predictions of the options theory.
  • Consumer demand for adjustable rate mortgages, Alm, J., & Follain, J. R. (1987). Housing Fin. Rev., 6, 1. This paper investigates what determine a household’s choice when it comes to choosing between ARM and fixed-rate mortgages. It develops a theoretical model that analyses using analytical and numerical models.
  • The valuation and analysis of adjustable rate mortgages, Kau, J. B., Keenan, D. C., Muller, W. J., & Epperson, J. F. (1990). Management Science, 36(12), 1417-1431.  This paper shows that there is a way of solving the problems arising from securities whose payoffs depend on the actual path of the underlying state. This requires the addition of one auxiliary state variable.
  • Choosing between fixed and adjustable rate mortgages: Note, Dhillon, U. S., Shilling, J. D., & Sirmans, C. F. (1987). Note. Journal of Money, Credit and Banking, 19(2), 260-267. This paper’s primary objective is examining the option of either fixed or adjustable rate mortgages.  It empirically attempts to investigate what effects that pricing and borrower characteristics have on the mortgage contract choice.
  • Prepayment risk in adjustable rate mortgages subject to initial year discounts: Some new evidence, Ambrose, B. W., & LaCourLittle, M. (2001). Real estate economics, 29(2), 305-327. This article utilizes the use of micro-level data to investigate ARM’s prepayment performance of using the methodology of competing for a risk that was developed by Deng, Quigley and Van Order (2000).
  • Anatomy of an ARM: The interest-rate risk of adjustable-rate mortgages, Stanton, R., & Wallace, N. (1999). The Journal of Real Estate Finance and Economics, 19(1), 49-67.  The article investigates and analyzes the dynamics of the indices which are commonly used for ARMs and then compares the effects of their time-series properties on the sensitivity of interest rates of ARMs.
  • Adjustable and fixed rate mortgage termination, option values and local market conditions: An empirical analysis, VanderHoff, J. (1996). Real Estate Economics, 24(3), 379-406. This paper uses data from the period of 1985-1992 to analyze the probabilities of prepayment or default for ARMs and Fixed Rate Mortgages.
  • Estimating the marginal contribution of adjustable-rate mortgage selection to termination probabilities in a nested model, Capone, C. A., & Cunningham, D. F. (1992). The Journal of Real Estate Finance and Economics, 5(4), 333-357. This study measures the marginal contribution of ARMs to probabilities of termination. It develops a nested-logic model of mortgage selection and termination which is modified and then uses it to identify the role played by risk adversity in the selection process.
  • Rational pricing of adjustable rate mortgages, Kau, J. B., Keenan, D. C., Muller III, W. J., & Epperson, J. F. (1985). Real Estate Economics, 13(2), 117-128. This paper develops a general method used for valuing ARMs, and then it produces a set of simulation results to show how the approach can be implemented. The approach is viewed as the main contribution of the paper.
  • The impact of financial sophistication on adjustable rate mortgage ownership, Smith, H. L., Finke, M. S., & Huston, S. J. (2011). This study uses regression analysis and descriptive statistics together with recent data from the Survey of Consumer Finances to reveal whether ARM borrowing is being driven by both the least and most financially sophisticated households even though it is for different reasons.
  • Why is the market share of adjustable-rate mortgages so low? Moench, E., Vickery, J., & Aragon, D. (2010). This paper investigates the reason as to why in the last several years the US homebuyers have been increasingly favoring fixed-rate mortgages to ARMs leading to a drop of ARMs to less than 10% of all the mortgage originations.

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