There are two types of loans; fixed rate loans and adjustable rate loans. As the names suggest, the interest rate charged on a fixed rate loan remains constant throughout the term of the loan. With adjustable rate loans, the interest rate fluctuates with changes in market conditions. There are advantages as well as disadvantages of both types of loans, so borrowers need to weigh them before signing any loan contract. Adjustable rate loans are also known as floating rate loans or variable rate loans.

How they Work

Adjustable rate mortgages, or ARMs, usually have two phases: a fixed rate phase; and variable rate phase. For instance, prospective homeowners may see 2/28 or 3/27 mortgages. The 2/28 simply means that the interest rate for the 30-year mortgage will be fixed for the first two years before it is reset to a floating rate mortgage. With a 3/27 mortgage, the fixed rate will apply for the first three years before the floating rate comes into effect. A floating interest rate has two components: a benchmark rate and an ARM margin.

a) Benchmark Rate

This rate is also known as the index value, reference interest rate, base interest rate or prime rate. The benchmark rate is usually calculated on a monthly basis. The Federal Reserve indirectly sets the benchmark rate by setting the Federal Funds rate, which is the basis of the base rate. The benchmark rate usually varies from month to month.

b) ARM Margin

Unlike the benchmark rate, the ARM margin is a fixed rate that is paid by borrowers on top of the base rate. The ARM margin is the difference between the actual mortgage rate and the benchmark rate. The ARM margin also contains the profit margin of the lender. When applying for a mortgage, borrowers can negotiate this rate with their lender.

When a prospective property owner applies for a mortgage, he or she may want to negotiate the benchmark rate as that will determine the affordability of the credit facility. If the ARM margin is set at 1.5%, while the benchmark rate is 5.1%, the adjustable interest rate will be 6.6%, at least for that month.

The Pros and Cons of Adjustable Rate Loans

Property owners often face a lot of difficulty choosing between adjustable rate loans and fixed rate mortgages. Both have their own unique advantages and disadvantages.

ARM Pros and Cons

When the economy is performing well, an ARM may have very low monthly payments. The interest rate paid is a reflection of market performance. With a fixed rate mortgage, the interest rate is determined beforehand and it will be applicable throughout the mortgage term. If the fixed rate is high, the borrower may be forced to refinance to enjoy lower rates. Unfortunately, refinancing can be costly. With ARMs, rates are brought down automatically to reflect the prevailing market conditions. The downside of ARMs is that rates may increase significantly if the government raises the base lending rate to counter rising inflation. This will lead to an increase in monthly payments.