The adjustable rate mortgage is a type of mortgage loan and a popular product for home financing. With it, the interest rate is adjusted periodically on the basis of different indices. Popular indices include the London Interbank Offered Rate, the Cost of Funds Index, and the 1-Year Constant-Maturity Treasury. Instead of using popular indices, some mortgage lenders employ their own cost of funds, ensuring a steady margin for the creditor. The funding cost is typically related to this index and as a result, the borrower’s payments can change with fluctuations in the interest rate. As another option, the loan’s term can change.
This mortgage type is not like the graduated payment mortgage where the interest rate is fixed while payment amounts change. Other mortgages include the balloon payment mortgage, the negative amortization mortgage, the interest only mortgage, and more.
The low initial cost is what attracts many borrowers to this type of mortgage. Most adjustable rate mortgages are offered with a low interest rate, making the payment amounts more affordable than those of the fixed rate mortgages. Payments are made at a low interest rate during the first years of the mortgage’s term.
On the downside, payments will increase and fluctuate over time. The amount of the increase cannot be predicted. So, if one’s income does not go up as to compensate, or the expenses are not cut down, the mortgage may become unaffordable. The situation is quite different with fixed rate mortgages where the payment amounts stay the same over the term of the mortgage.
There are several types of adjustable rate mortgages. The hybrid ARM is a combination between the adjustable and fixed rate mortgage. During the first couple of years of the mortgage term, the borrower makes payments at a fixed interest while the remainder is due at an adjustable interest rate. The option ARM gives borrowers a choice as to the amount of payments. This can be a minimum payment, which is below the interest-only payment or interest only payments. The mortgage adjusts on a month-to-month basis while the payment adjusts annually. With this type of mortgage, however, comes a risk of negative amortization. It can happen if the monthly payments cannot cover the loan’s interest which results in an increased mortgage balance.
In spite of some drawbacks that come with the adjustable rate mortgage, it is a smart decision is some cases. For example, this mortgage may be a better choice for homeowners who plan to resell their property within 5 to 7 years. For those whose income is likely to increase over time, the adjustable rate mortgage is also a good option. They will have the convenience of low payments during the initial period. With income increase, they will be able to cover the payment amounts when they increase.
In Canada, the variable rate mortgage is offered by different institutions. CIBC, for example, offers a variable rate open mortgage with an interest rate of 3.80 percent and a term of 5 years. When the prime rate of the bank goes down, more of the borrower’s payment will go toward the principle. When the interest rate rises, more of the payment is used to pay the interest. Borrowers are allowed to make additional payments, repaying up to 100 percent of the mortgage.