An adjustable rate mortgage is a mortgage loan where the interest rate on the note is adjusted based on market interest rates and indices. The more common indicators are 1 year Treasury-bill securities, the COFI index and the LIBOR (London InterBank Lending Rate). Other forms of mortgage loans include the interest-only mortgage, fixed rate mortgage, negative amortization mortgage and balloon payment mortgage.
Typically adjustable rate mortgages apply more mortgage-rate risk to the borrower from the lender. In many cases they are used during periods when unpredictable interest rate conditions make fixed-rate mortgages unattainable. Usually the borrower can benefit if market conditions force interest rates to fall, but also it can be detrimental if interest rates increase causing payments to become unmanageable based on original debt/income ratios.
If a homeowner, for instance, think that he or she can manage a set monthly mortgage payment, an increase by only 1% or 2% can make the monthly costs skyrocket from the original amount. Adjustable-rates were over-used during the real estate boom and in many cases sold to borrowers who did not fully understand the downside risk of those adjustments.
Currently interest rates are at historic lows so for those interested in purchasing a home or other property it is a good time to lock in a low fixed-rate mortgage. Option ARMs have been used a lot in the past because they are usually offered with a very low “teaser” rate (often as low as 1%) which means low payments for the first year of the ARM. During the past real estate boom, lenders had been underwriting borrowers based on mortgage payments that are below the fully amortizing payment level. This enables borrowers to qualify for a much larger loan (i.e., take on more debt) than would otherwise be possible.
For Option ARMs, diligent borrowers will not focus on the teaser rate or initial payment level, but will consider the characteristics of the index, the size of the “mortgage margin” that is added to the index value, and the other terms of the ARM. Specifically, they need to consider the possibilities that (1) long-term interest rates go up; (2) their home may not appreciate or may even lose value or even (3) that both risks may materialize. Option ARM’s are usually best suited to borrowers with increasing projected incomes, whereby a high adjustment can be dealt with through the monthly household income. For those borrowers who do not have flexibility in future earnings, it is often times too hard to make payments if interest rates increase in a short period of time. In many cases it can lead to a payment that is altogether unmanageable, and ultimately missed payment can lead to foreclosure.