Adjustable Rate Mortgage – Definition

variable-rate mortgageadjustable-rate mortgage (ARM), 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 (CMT) securities, the cost of funds index (COFI), and the London Interbank Offered Rate (LIBOR). 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 (alternatively, the term of the loan may change). 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 benefits from reduced margins to the underlying cost of borrowing compared to fixed or capped rate mortgages.

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 (the index plus the margin).
  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.

Reasons for ARMs

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 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 will typically have much shorter terms than residential mortgages. If a bank were to offer large volumes of mortgages at fixed rates but to derive most of its funding from deposits (or other short-term sources of funds), the bank would have an asset–liability mismatch due to interest rate risk: in this case, it would 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 this problem, that the savings and loans companies had short-term deposits and long-term, fixed rate mortgages, and 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 place tight restrictions on the amount of long-term fixed-rate mortgages that banks may hold (in relation to their other assets). To reduce this risk, many mortgage originators will 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 (typically one month to one year) 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.

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