© 2015 Shmoop University, Inc. All rights reserved.
Finance

Finance

Home Finance Mortgages Adjustable Rate Mortgages

Adjustable Rate Mortgages

You're flexible. You listen to Mozart, Taylor Swift, and the Beatles. You can appreciate a good Judd Apatow movie and the original Star Wars, and just last week, you saw that subtitled film and only fell asleep for fifteen minutes.

So a flexible mortgage might be right for you…maybe?

An adjustable rate mortgage (ARM) is a home loan where the interest rate changes over time. That's what the banks will tell you, at least. In reality, it's likely that the interest rate will go up.

But wait. It can still be a good thing. If…

  • you're just starting out in your career. If you want to get a house now but you're still fetching coffee at your entry-level job, you might be okay with having your monthly payments go up as your salary does—especially if the bank can offer you better rates on an ARM than on a fixed rate mortgage.
  • interest rates are high. If interest rates are high now and you get a fixed rate mortgage, you're stuck with your current rate until you re-finance (and that's a pain) or you pay the mortgage off (also a pain). With an ARM, your rates may eventually go down so you won't be locked into a higher rate.
  • interest rates are expected to go higher. If you're buying at a time when interest rates are expected to go higher, you'll likely get a better rate on an ARM than you would on a fixed interest rate.
  • you like to be surprised sometimes.

ARMs by the Numbers

When talking about adjustable rate mortgages with your banker, there are a few numbers you'll want to pay attention to (even if you have perfected the fine art of sleeping with your eyes open):

  • Your guaranteed period of time for the initial interest rate. Let's face it: you're probably considering ARMs because the interest rate is good. It's supposed to be. But how long until that rate can go up?
  • The index used to adjust the rate. Usually it's LIBOR or something similar, but it's good to check. You don't want the bank using a wind sock or psychic hotline to set your rate.
  • The step up percentage. This is the amount the bank predicts the interest rate will grow each year. It's a good rule of thumb meant to keep you from being too panicked as your rate increases. Just keep in mind that the numbers may be scarier.
  • A cap. No, not the fetching chapeau you wore to the races last fall. This cap refers to the maximum rate the bank will charge on your ARM. Not all mortgages offer this, but it is nice to have since it ensures that things won't spiral too far out of control.

Hedging Your Bets

Are you feeling lucky?

Some ARMs allow you to pay only interest on your loan for the first couple of years. Your monthly payments are nice and low, but you're not paying down any of the amount you actually borrowed. What you're doing is hoping (and silently pleading) that your income will go up and interest rates will go down in the next few years, so that by the time you need to start repaying the principal, your mortgage rates will have dropped.

It could happen.

Then again, so could time travel.

Mortgage By the Numbers

Will an ARM save you money? Your initial payments may be less, but banks price mortgages carefully. You might get lucky—or you might end up paying more than your neighbor with the fixed rate mortgage and the higher monthly bills.

Let's say you lock in an ARM at 3.75% for five years with a 12% cap and a 0.25% step up. Your schedule for a $250,000 mortgage might look something like this:


YearInterest RateMonthly PaymentAnnual Payment
1-53.75%$1,111$13,338
64.00%$1,141$13,693
156.50%$1,399$16,526
3010.00%$1,572$18864

What if all the numbers were the same but your step up was 1%? The numbers would look very different toward the middle and end of your repayment schedule:


YearInterest RateMonthly PaymentAnnual Payment
1-53.75%$1,111$13,338
64.75%$1,232$14,790
1512.00%$2,146$25,753
3012.00%$2,146$25,756

Your neighbor with the higher initial payments may get the last laugh if he has the same amount borrowed but a fixed rate mortgage with a schedule that looks like this:


YearInterest RateMonthly PaymentAnnual Payment
1-55.25%$1,325$15,903
65.25%$1,325$15,903
155.25%$1,325$15,903
305.25%$1,325$15,903

You might feel smug at first when you've got more money each month for takeout and Netflix, but you may regret it in 15 years when you're sweating the bills and your neighbor can afford that new ride-on mower.

Then again, if you have a fab new job, the rate increase might not even be worth the dust under your futuristic high-tech Louboutins of the future. If so, you can pat yourself on the back for saving a few bucks and enjoying them during your youth.

People who Shmooped this also Shmooped...

Advertisement
Advertisement