Adjustable rate mortgages (ARMs) or Variable rate mortgages (VRMs) refer to mortgage loans (loans secured by real estate) in which the interest rate is adjusted at pre-determined regular intervals according to the movements of a market index rate, as opposed to being fixed throughout the term of the loan (as is the case in fixed-rate mortgages).
Typically, the interest rate of an ARM is determined by adding or subtracting to the Index Rate a predetermined spread, or margin. In the beginning of each interval (referred to as adjustment period) the motrgage rate is adjusted, depending on whether the Index Rate increases or decreases. The Index Rates most commonly used in adjustable rate mortgages are the one-, three-, or five-year Treasury Bill rates. The spread or margin represents the percentage points (or basis points) that are added or subtracted from the Index Rate by the lender in order to determine the mortgage rate for each adjustment period. Note that the margin remains constant throughout the term of the loan.
An adjustable-rate mortgage generally has a fixed-interest rate for a set number of months at the beginning, before the rate starts fluctuating according to Index Rate movements. The level that the Interest rate of an ARM can reach through adjustments is not unlimited. ARMs incorporate caps, that is, limits on how high or low the interest rate or mortgage payments can go. Depending on the contract terms provided by the lender, these interest rate caps may be allowed to change at the end of each adjustment period or remain constant over the life of the loan.
ARMs and High-Return Investing
Adjustable rate mortgages are provided typically at lower interest rate than the fixed-rate loans, because they entail less risk on the part of the lender (in case that rates go up). In this sense, adjustable rate mortgages impose less interest rate and debt service burden to the investor in the short-term at least. In the long-term that may not be case if the market rate moves above the rate that the investor would secure, if a fixed-rate loan was made. This risk can be mitigated to some extent by switching to a fixed-rate mortgage as soon as rates start rising.
For invstors that buy income-producing property and are looking for the lowest rate so that the rental income of the property can cover as much of the mortgage payment as possible, ARMs look surely more attractive, especially if the investment strategy is to hold the property for a short-period and then resell it.
For long-term investors the ARM entails significant risks. One of the major risks of using ARMs is the unpredictability of the debt service and therefore the cash flow of the property. In this sense the use of an ARM makes more difficult the projection of the investment cash flows and the estimation of the potential returns. Most importantly, it adds another important factor of uncertainty regarding the achievable return by the investment. However, the analyst can still estimate the lower limit and upper limit of potential returns by assuming the worst and best case debt service scenario. The worst case scenario is the one that assumes that the initial rate increases every adjustment period by the contract-stated margin until it reaches the maximum interest rate allowed by the mortgage contract. The best case scenario is the one that assumes that the initial rate decreases every adjustment period by the contract-stated margin until it reaches the minimum interest rate allowed by the mortgage contract.