variable-rate mortgage, Adjustable Rate Mortgage (ARM), or tracker mortgage
is a mortgage loan with the interest rate on the note periodically adjusted
based on an index which reflects the cost to the lender of borrowing on the
credit markets. The loan may be offered at the lender's standard variable
rate / base rate. There may be a direct and legally defined link to the
underlying index, but where the lender offers no specific link to the
underlying market of index they can choose to increase or decrease at their
discretion. The term 'variable-rate mortgage' is most common outside the
United States, whilst in the United States, 'adjustable-rate mortgage' is
most common, and implies a mortgage regulated by the Federal government,
with limitations on charges ("caps").
countries, adjustable rate mortgages are the norm, and in such places, may
simply be referred to as mortgages. Among the most common indices are the
rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of
Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). A few
lenders use their own cost of funds as an index, rather than using other
indices. This is done to ensure a steady margin for the lender, whose own
cost of funding will usually be related to the index.
Consequently, payments made by the borrower may change over time with the
changing interest rate (alternatively, the term of the loan may change).
This is not to be confused with the graduated payment mortgage, which offers
changing payment amounts but a fixed interest rate. Other forms of mortgage
loan include the interest only mortgage, the fixed rate mortgage, the
negative amortization mortgage, and the balloon payment mortgage.
Adjustable rates transfer part of the interest rate risk from the lender to
the borrower. They can be used where unpredictable interest rates make fixed
rate loans difficult to obtain. The borrower benefits if the interest rate
falls but loses if the interest rate increases. The borrower benefits from
reduced margins to the underlying cost of borrowing compared to fixed or
capped rate mortgages.
In some countries, banks may
publish a prime lending rate which is used as the index. The index may be
applied in one of three ways: directly, on a rate plus margin basis, or
based on index movement. A directly applied index means that the interest
rate changes exactly with the index. In other words, the interest rate on
the note exactly equals the index. Of the above indices, only the contract
rate index is applied directly.
To apply an index on a rate plus margin basis means that the interest rate
will equal the underlying index plus a margin. The margin is specified in
the note and remains fixed over the life of the loan. For example, a
mortgage interest rate may be specified in the note as being LIBOR plus 2%,
2% being the margin and LIBOR being the index. The final way to apply an
index is on a movement basis. In this scheme, the mortgage is originated at
an agreed upon rate, then adjusted based on the movement of the index.
Unlike direct or index plus margin, the initial rate is not explicitly tied
to any index; the adjustments are tied to an index.
ARMs generally permit borrowers
to lower their initial payments if they are willing to assume the risk of
interest rate changes. In many countries, banks or similar financial
institutions are the primary originators of mortgages. For banks that are
funded from customer deposits, the customer deposits will typically have
much shorter terms than residential mortgages. If a bank were to offer large
volumes of mortgages at fixed rates but to derive most of its funding from
deposits (or other short-term sources of funds), the bank would have an
asset-liability mismatch: in this case, it would be running the risk that
the interest income from its mortgage portfolio would be less than it needed
to pay its depositors. In the United States, some argue that the savings and
loan crisis was in part caused by this problem, that the savings and loans
companies had short-term deposits and long-term, fixed rate mortgages, and
were caught when Paul Volcker raised interest rates in the early 1980s.
Therefore, banks and other financial institutions offer adjustable rate
mortgages because it reduces risk and matches their sources of funding.
Banking regulators pay close attention to asset-liability mismatches to
avoid such problems, and place tight restrictions on the amount of long-term
fixed-rate mortgages that banks may hold (in relation to their other
assets). To reduce this risk, many mortgage originators will sell many of
their mortgages, particularly the mortgages with fixed rates.
For the borrower, adjustable rate mortgages may be less expensive, but at
the price of bearing higher risk. Many ARMs have 'teaser periods', which are
relatively short initial fixed-rate periods (typically one month to one
year) when the ARM bears an interest rate that is substantially below the
'fully indexed' rate. The teaser period may induce some borrowers to view an
ARM as more of a bargain than it really represents. A low teaser rate
predisposes an ARM to sustain above-average payment increases.