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Finance

What is an Adjustable Rate Mortgage?

Diana Bocco
By Diana Bocco
Updated May 17, 2024
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An adjustable rate mortgage, also known as ARM or floating rate mortgage, is a type of mortgage with a flexible interest rate. This means the percentage rate fluctuates based on an index, and it is adjusted to always benefit the lender, not matter how the market changes. There are basically five types of indexes used to calculate the interest rate on adjustable rate mortgage. These are: the Constant Maturity Treasury (CMT), the 11th District Cost of Funds Index (COFI), the 12-month Treasury Average Index (MTA), the National Average Contract Mortgage Rate, and the London Interbank Offered Rate (LIBOR).

An adjustable rate mortgage is a common solution for financial institutions that cannot afford the risk of fixed loans, such as banks funded by customer deposits only, or for loan companies offering a loan to people without a credit history, or those requesting a rather large loan. An adjustable rate mortgage is not necessarily a bad arrangement for the borrower, just a more risky one. In the case of the index falling, the borrower may end up paying less than he would on a regular mortgage loan. In fact, an adjustable rate mortgage is the most common type of mortgage offered by banks in Canada, the United Kingdom, and Australia. Short-term loans can be fixed in these countries, but any loan or mortgage over ten years will normally take the form of an adjustable rate mortgage.

An adjustable rate mortgage often comes with a cap or limitation on charges, which controls either the frequency or the lifetime change of the interest rate. For example, an adjustable rate mortgage can have a cap of a two percent maximum per year, or six percent total during the lifetime of the mortgage. This protects the borrower while still ensuring the lender a fairly safe transaction. Another type of borrower protection is the adoption of a hybrid adjustable-rate mortgage, in which the interest rate only becomes floating after a certain period of time, like a year or so. This gives the borrower the chance to adjust his or her lifestyle enough to deal with the rate change without any major consequences.

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Discussion Comments

By Melonlity — On Mar 30, 2014

@Vincenzo -- what you have described is what took down the subprime mortgage market. A major problem is that banks operating in that market issued risky mortgages to people who could barely meet those comparatively low initial payments and were certainly unable to pay their higher monthly payments when rates reset.

How do banks in other nations defend against assuming too much risk? Not sure about that, but I do know that steps have been taken in America to discourage issuing such risky mortgages.

By Vincenzo — On Mar 29, 2014

It is surprising to learn that adjustable rate mortgages are common in some countries. After all, those mortgages were right at the heart of the credit crisis that hit the United States around 2007 and 2008. The thing about fixed-rate mortgages in the United States, at least, is that the interest rates on them generally reset after five years. During the so-called housing market crisis in the late-2000s, a lot of people found their mortgage payments went up hundreds of dollars per month when the rates reset and they couldn't afford to pay them.

A record number of foreclosures followed.

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