An adjustable-rate mortgage (ARM) provides for varying interest rates over the life of the mortgage. It forces the borrower to shoulder some of the risks that fixed-rate loans place on the lender. Key to the rationale for ARMs is the almost one-to-one relationship between short-term interest rates and inflation rates. Over the life of a 30-year, fixedrate mortgage, inflation ranks among the biggest enemies that a lender faces. Increases in the inflation rate reduce the real (inflation-adjusted) rate of interest that a mortgage pays to a lender. Higher inflation reduces the real purchasing power of each monthly payment while pushing up the real operating cost of a lender. If the inflation rate happens to rise above a mortgage interest rate, the lender ends up earning a negative real interest rate.
The high inflation rates of the 1970s taught lenders the damage that inflation can wreak on the interest income earned from mortgages. Lenders began demanding higher interest rates on 30-year mortgages as insurance against a wave of inflation wiping out the profits and capital of mortgage holders. Adjustable-rate mortgages developed as a way to get home buyers into houses without paying the high interest rates attached to 30-year, fixed-rate mortgages.
Under an ARM, the mortgage interest rate at any given time is linked or indexed to a short-term interest rate. Two short-term, benchmark interest rates commonly used for setting ARM interest rates are the London Interbank Offered Rate (LIBOR) and the one-year, constant maturity treasury bond rate. The interest rate on an ARM is adjusted periodically to reflect changes in a benchmark interest rate. The home buyer benefits because short-term interest rates are usually lower than long-term interest rates, since short-term rates have less inflation risk. The disadvantage to the home buyer lies in the risk that short-term interest rates go up, probably because of rising inflation or anti-inflation policies. If short-term interest rates go up, the monthly payments on ARMs go up. With ARMs, the burden of accelerated inflation is born by the borrower instead of the lender. In turn for bearing the risk of accelerated future inflation, the home buyer stands a chance getting by with lower interest rates. If inflation never drives up short-term interest rates over the life of the loan, the home buyer comes out ahead.
Adjustable-rate mortgages come in several varieties. In some mortgages, the monthly payment can change every month, depending on the benchmark interest rate. Other mortgages allow changes in monthly payments as infrequently as every five years. The time frame between rate changes is called the “adjustment period.” A mortgage with a one-year adjustment period is called a one-year ARM.
Many ARMs put a cap on the amount that a mortgage interest rate can change from one adjustment period to the next. This provision protects home buyers from large jumps in interest rates and monthly payments. Other contracts put a limit on the amount that monthly payments can increase from one adjustment period to the next. If interest rate adjustments call for a 10 percent increase in monthly payments, but the contract only allows monthly payments to go up 5 percent, then the unpaid interest will be added to the balance of the mortgage. By law, nearly all ARMs have a cap on how high interest rates can go over the life of a mortgage.
One version of the ARM allows the home buyer to pay an initial interest rate well below the benchmark interest rate used for setting an ARM interest rate. The home buyer enjoys the low interest rate, often called a teaser rate, for an initial period, such as a year. Then the interest rate is adjusted upward according to the indexing formula tied to the benchmark interest rate. If shortterm interest rates happen to be rising at the same time that a homeowner is transitioning from the teaser rate to the fully indexed, benchmark rate, then the home owner may experience “payment shock.” The large increase in monthly payment may leave a home owner unable to make a house payment. The practice of offering teaser rates contributed to the severity of the subprime mortgage crisis in the United States.
See also: U.S. Financial Crisis of 2008–2009
