Mortgages and Mortgage Types (continued)

Adjustable Rate Mortgages (ARMs)

Adjustable rate mortgages are quite different to fixed rate mortgages. With an adjustable rate mortgage, the rate of interest can be varied by the lender (within specified constraints) both after an initial period and then at every interest rate review date. Adjustable rate mortgages invariably specify a rate of interest for an initial period which is lower than the current assessed market rate of the mortgage to that particular borrower, but subsequent adjustments tend to compensate the lender by applying rates which are higher than the assessed initial rate. In this way, adjustable rate mortgages are designed to attract borrowers to a particular lender and to a particular mortgage type.

The initial fixed-rate period for an adjustable rate mortgage varies widely. It can range from as little as one month to more than five years. Subsequent interest rate reviews commonly occur every year thereafter, although some mortgages specify much longer review periods, such as five years.

Interest rate changes for adjustable rate mortgages occur according to a specified formula, in which the adjusted rate is calculated as a particular index rate plus a pre-determined loan margin. Loan margins are negotiable, but are commonly set in the range of 2.0% to 3.0% per annum. For example, if the value of the particular index is 3.5% per annum on the rate review date, and the margin is 2.5% per annum, then the adjusted interest rate will be 6.0% (3.5% + 2.5%).

There are many, many variables which can apply to adjustable rate mortgages, all of which can confuse prospective borrowers and make comparisons very difficult without expert assistance. For example, some adjustable rate mortgage contracts allow 'negative amortization' such that regular payments are less than the interest which accrues on the mortgage. In these cases the interest deficit is added to the principal outstanding, so that the loan amount actually increases over time.

Seek Advice

Our recommendation is that you seek independent, professional advice. It is most important that the advice is sought from someone:

who you trust;
who is, on enquiry by you, competent to provide that advice; and
who has no conflict of interest in providing that advice to you.

Clearly this means, for example, that the advice of loan officers of mortgage lenders must not be relied upon by you in making contractual decisions on any mortgage, as their task is to arrange and complete home mortgage contracts. Their first duty, necessarily, lies with the mortgage lender.

Be particularly careful with adjustable rate mortgages, as this type of home mortgage can be quite complex.