What is an Adjustable Rate Mortgage?

What is an Adjustable Rate Mortgage?

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When buying a home, you’ll almost certainly need to take out a mortgage. There are a number of alternatives open to you and it’s well worth being aware of what’s out there. Knowledge is power, and by weighing up the pros and cons of each option, you’ll be well-placed to make the choice that is best for you. 

To help you make your decision, we’ve created a series of mortgage specials, focusing on the different products available to homeowners. In part one, we took a look at fixed rate mortgages. Part two discussed variable rate mortgages, and in this third part we’ll delve into adjustable rate mortgages.

The Basics

An adjustable rate mortgage is a type of variable rate mortgage, and it works in a similar fashion. As market rates rise and fall, so too does the amount of interest you will pay on your monthly repayments, and so adjustable rate mortgage repayments will increase or decrease. But this only happens after a period of repayment at a fixed introductory rate, usually one that is very attractive to the borrower.

The Benefits of an Adjustable Rate Mortgage

The introductory rate will always be lower than a fixed rate mortgage, usually by at least 1%, often more. This introductory rate can apply for anything from one month to as much as ten years, depending on your lender, saving you money when you probably need it most.

An adjustable rate mortgage can work extremely well for homeowners who are looking to take advantage of low rates and perhaps intend to move house after a few years or who expect to be earning much more in the future. The rules which govern the fluctuations that can occur after the introductory period can be complicated, but they are specified in the agreement and so any changes shouldn’t be completely unexpected.

The Disadvantages of an Adjustable Rate Mortgage

However, in terms of interest rates, what goes down can also go up. And as interest rates rise, so too do your monthly repayments, after the introductory period. No one can be 100% certain which direction the market will go or that rates will not rise drastically. This makes an adjustable rate mortgage more of a gamble than other options, and can make it difficult to budget accurately.

Interest rates can rise quickly and unexpectedly, and if you’re on a tight budget, you might not be able to comfortably cover the additional cost. This uncertainty can be stressful if you don’t have an adequate buffer zone, and missed payments can lead to foreclosure, as was too often the case during the 2008 crash in the U.S. especially.

Making the Most Out of an Adjustable Rate Mortgage

Adjustable rate mortgages are typically favoured by homeowners who are focusing on the short to medium term. In particular, investors who plan to sell before interest rates increase too much are attracted to this option. This is often dependent on the market rates, paired with the length of the introductory rate period. Whether the lender enforces penalties for early payment can also be a factor.

It’s not such a good choice for those on a tight budget. While the low introductory rates may be attractive, once the introductory period is over, the monthly payments can rise considerably depending on the market. If you can’t afford to comfortably pay extra, it’s better to go with a more stable, fixed-rate mortgage.

Doing your research is vital, so ensure you fully understand the terms of your loan, including any caps—the limit on how far the interest rate can rise during a particular period—and the adjustment frequency. An adjustable rate mortgage can save you a lot of cash in the right circumstances, but there are risks, and poor planning can lead to foreclosure.

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