With an adjustable mortgage rate, a homebuyer can expect to receive an initial mortgage rate that’s about 1% less than comparable fixed mortgage rates. If the U.S. prime rate (a short-term interest rate used as an index) remains stable or drops in the future, that homebuyer (now the mortgagee) can expect to pay less interest on the same amount of principle than if he/she had obtained a fixed mortgage.
Adjustable-rate mortgages (ARMs) are attractive to many potential borrowers because the initial mortgage rates are generally lower than the rates for fixed mortgages obtained during the same timeframe. Depending on the margin, the rate cap and the term length during the initial payment period, an adjustable mortgage rate can potentially save you money on interest.
The mortgage rate on an ARM fluctuates over the entire life of the loan. Adjustable mortgage rates are modified based on a predetermined economic index and a set margin, all established at the beginning of the loan. A rate cap is also usually applied to prevent massive increases in the mortgage rate. Types of indexes that are used to determine current mortgage rates are the Constant Maturity Treasury (CMT), Treasury Bill (T-Bill), 12-Month Treasury Average (MTA or MAT), and Certificate of Deposit Index (CODI), among others.
As an example, assume that your ARM’s initial mortgage rate is 4.5%, the margin is 2.5%, and the lifetime rate cap is 5.0%. If the current index is 8.0%, your mortgage rate would be:
- 8.0% (index) + 2.5% (margin) = 10.5% rate
However, since there is a lifetime cap of 5.0% on your mortgage rate, the maximum rate you can be charged on the loan is 9.5% (because 4.5% + 5.0% = 9.5%).
Within the adjustable mortgage rate family, there are various types of loans suited for homebuyers with different needs. Payment-option ARMs, for example, help accommodate borrowers who have fluctuating cash flow by allowing them to make different types of monthly payments (such as minimum payments and interest-only payments). It is wise to thoroughly understand these payment options as you will need to be prepared for a possible sudden increase (called payment shock).
There are pros and cons for every type of mortgage loan. Some economists argue that around 88% of homebuyers could have saved money if they had opted for adjustable mortgage rates. However, with mortgage rates at historically low levels ― and forecasts that rates will begin climbing again soon ― obtaining a mortgage (or refinancing your current loan) is a decision that requires definite research and sound speculation.