What is an Adjustable Rate Mortgage and How Does it Work?

Posted May 2, 2023


Mortgage rates for both personal residential use and investment purchases are volatile and can significantly impact the cost of your purchase. When interest rates are low, buyers can afford to buy a more expensive house, and when rates rise, the housing market often experiences lower activity. For lenders, rising interest rates can affect their bottom line if customers have mortgages locked in for thirty years at a lower rate than the institution needs to pay to borrow money.

In fact, ARM (adjustable rate mortgage) loans started showing up in the early 1980s when interest rates were rising rapidly. Lenders might be paying 15 percent or more for funds, while some customers had loans with interest rates below ten percent. In addition, new customers had a hard time paying the 18 percent rates that were common at that time.

Adjustable rate loans have variable interest rates.

You can usually get an adjustable-rate loan with a slightly lower rate than you would be able to find for a fixed-rate loan. This option helps the borrower, but it also protects the lender from having a portfolio of loans that are effectively costing them money. The ARM adjustment schedule varies from one lender to another, and the rate can be based on the Prime Rate, the LIBOR, or the 30-day Treasury rate, plus a margin.

The rate is typically fixed for the first few years (as few as one and as many as seven) and then subject to periodic adjustments to match the current prevailing rate. Most of the loans will have parameters to limit the increases overall and at any time.

Fixed-rate loans have higher interest rates.

In almost any rate environment, the pricing for a 30-year fixed loan will be higher than the rate available for a loan with an adjustment built in. Also, a 15-year fixed mortgage loan will have higher payments than a 30-year loan but may be available with a slightly lower rate since the lender isn’t accepting the same length of exposure to rising rates.

ARMs increase when rates rise.

Not surprisingly, consumers prefer the safety of a fixed-rate loan as long as the rate isn’t high enough to thwart their ability to buy a home. As fixed rates rise, adjustable-rate loans look more attractive. In fact, the Urban Institute reported that at the end of 2022, ARMs made up 12 percent of total mortgage production, compared to 3.3 percent a year earlier. 

While some fear a new increase in ARM prevalence, citing their influence on the housing and economic crash of 2008, others point to the changes in ARM qualification that were a significant part of that meltdown. Before 2005 lenders required higher lending qualifications for ARM borrowers to ensure they had the resources to withstand the potential of a rate increase. The breakdown of those requirements made them riskier than traditional fixed-rate loans.2 Of course, ARMs were not only more widespread and less regulated, but they were also even available with negative amortization. With that feature, initial payments failed to cover the total principal and interest due, allowing the loan balance to grow. The only way these loans could work was if the property value continued to increase. Ultimately, that strategy failed, and the layered risk helped the market to implode.

Current ARMs have more robust controls.

The Urban Institute reviewed data from Fannie Mae and Freddie Mac for 2020 to 2022 and reports that most ARM loans have a fixed period of seven years, and a solid third have a ten-year fixed term. These extended periods reduce the risk that homeowners or investors will unexpectedly encounter a significant rate increase without resources.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

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