Adjustable-Rate Mortgages – The Pros and Cons

An adjustable-rate mortgage (“ARM”) is a mortgage loan with an adjustable interest rate. The adjustments are made to the mortgage rate on a periodic basis and can be as frequent as monthly or on a less frequent basis, such as annually.

Traditionally adjustable-rate mortgages have an initial rate fixed period before shifting to an adjustable-rate over the remainder of the loan term.

The interest rate is derived from a benchmark and ARM margin. Generally, the benchmark is based on either, 1-year U.S Treasuries, LIBOR (London Interbank Offered Rate) or 11^th District Cost of Funds Index.

It is the benchmark component of the adjustable-rate mortgage that is the variable. The ARM Margin is a fixed rate throughout the term of the mortgage loan.

ARMs include rate caps that limit the impact of rising interest rates on an ARM.

Advantages

• ARMs tend to have lower interest rates in the early part of the mortgage term, which tends to be the fixed period. The rates are traditionally lower than those offered in fixed mortgages. This benefits homes buyers looking to own a home for a shorter period of time.
• Flexibility in selecting the fixed interest rate period is an advantage. This allows prospective homeowners to benefit from lower rates for longer.
• ARMs increase the purchasing power of homeowners. ARM rates are based on shorter-term interest rates. Short-term interest rates are traditionally lower than long-term interest rates. The lower interest rate allows applicants to buy more expensive homes due to the lower rates.

Disadvantages

• While ARMs do have their interest rates capped, monthly payments are a variable and can materially affect disposable incomes in rising interest rate environments.
• Very rarely will the ARM interest rate fall after the fixed period. The initial period is an enticer, luring prospective applicants with a lower rate than those offered for fixed-rate mortgages.
• Prospective applicants need to clearly understand the benchmark.
• One benchmark could have greater volatility than another. Understanding and selecting the most appropriate ARM benchmark is an important step in the process.

In Summary

Prospective home buyers need to consider the advantages and disadvantages of an adjustable-rate mortgage carefully. There is certainly greater flexibility for those planning on holding the mortgage for a shorter period of time.

Advantages to an ARM can fall away as the hold period of a mortgage lengthens.

Uncertainty over the interest rate environment in 5 or even 10 year leaves ARM mortgage holders exposed to the prospect of materially higher monthly repayments.

Since last November, as fixed mortgage rates have been on the slide, the level of interest in ARMs has been on the rise. The allure of even lower mortgage rates has ultimately reignited appetite for ARMs.

Financial advisors likely consider the current economic cycle to be near its peak. Such an outlook would suggest that further upside in interest rates is limited. Some caution is required, however.

The spread between an ARM and fixed-rate mortgages could converge should economic conditions worsen. Such an event would reduce the attractiveness of an ARM, particularly if the fixed term of the ARM is beyond 1-year.

One last thing to also consider is the property market itself. Inventories have been tight in recent years. This has led to homeowners owning their properties for longer. When considering the fact that holding an ARM beyond the fixed interest period is a disadvantage, inventories can also become a factor.