What is an Adjustable Rate Mortgage and How Does it Work?

Adjustable Rate Mortgage Work
David Andrew
By: David Andrew
Updated: July 25, 2014
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When you apply for a mortgage loan, you will have the choice between a fixed rate mortgage and an adjustable rate mortgage.

A fixed rate mortgage is simpler to understand. You lock in your interest rate and your mortgage payments will always stay the same.

The adjustable rate mortgage is a bit more complicated to understand but could work out as a better choice in some situations.

What is an adjustable rate mortgage?

When you have an adjustable rate mortgage, the interest rate on your loan will change over time. That is why the loan is considered adjustable.

When you first take out a loan, it will lock in a rate for the first two or three years, so your monthly payments will be the same during this time. After this period, your interest rate will start changing, which means your monthly mortgage payments will go up and down.

Many adjustable rate mortgages readjust the amount you will owe every single month. They can be unpredictable.

“When rates go down, your 

payments will be less expensive.”

How does the rate change?

An adjustable rate mortgage bases its cost on the market interest rate. When market rates go up, your payments will become more expensive.

Your loan will list some restrictions based on how much it can change, so it is not totally unpredictable.

For example, if you start at a 4 percent interest rate, your loan might only be able to change by at most another 3 percent each year up to a maximum rate of 12 percent.

When is an adjustable rate mortgage a good choice?

If you do not think you can afford the payments on a fixed rate mortgage, an adjustable rate mortgage could be the way to afford your dream home.

Lenders typically charge less for these loans at the beginning because they can increase the cost should market rates go up. Since a fixed rate locks in your mortgage price, lenders charge more for this guarantee.

You can use your adjustable rate for a few years until your financial situation improves to the point where you could afford a fixed rate mortgage. Then you can refinance to a fixed rate loan.

Another reason to take an adjustable rate mortgage is if you think market rates are about to go down. In this case, a fixed rate loan would be locking in a price that will soon be more expensive than the market price.

By choosing an adjustable rate loan, you will ensure your payments go down as the market rate goes down.

While it takes a bit more research to decide whether an adjustable rate mortgage makes sense, this effort could pay off in a better loan. Be sure to consider both your fixed and adjustable mortgage options before buying your new home.

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