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Understanding Adjustable Rate LoansBy Rita Lambros-Segur, M.H.
An adjustable rate loan is a mortgage loan where the interest rate is adjusted periodically based on an index. This is done so the lender will be guaranteed a steady margin, since the cost of funding normally relates to the index. With an adjustable rate loan, the borrower can change the payments over time as the interest rate changes, but sometimes the duration of the loan will change as well. Adjustable rate loans are used when unpredictable rates make fixed rate loans hard to obtain.
Adjustable rate loans are typically characterized by their index, and their limitations on charges, which are referred to as caps. In many countries throughout the world, adjustable rate loans are the norm, and are referred to as mortgages rather than adjustable rate loans.
All adjustable rate loans have an adjustable interest rate that is tied to an index, and the index varies from bank to bank. Most banks publish a prime lending rate and use it as the index, and it can be applied in one of three different ways. It can be applied directly to the loan, on a rate plus margin basis, or applied based on an index movement.
When an index is directly applied, the interest rate will change at the same time as the index. The interest rate on the loan will be exactly equal to the index, and will change each time the index changes.
When it is applied on a rate plus a margin basis, the interest rate will be equal to the underlying index along with a margin. The margin is determined at the same time as the loan, and will remain the same throughout the entire duration of the loan. A movement basis applied index means that a rate is agreed upon when the loan first originates, and then will change when the index is moved.
Because adjustable rate loans can sometimes bring financial hardship to the borrower if the payment increases, limitations are placed on adjustable loans. These limitations are referred to as caps, and they are a very common feature of almost every adjustable rate loan.
Caps can affect the frequency of the interest rate change, periodic changes in the interest rate, and the total change in interest over the entire duration of the loan. The caps can guarantee that the interest rate will not exceed a certain amount; the monthly payments will not increase over a certain amount; and the duration of the loan will not be stretched out past a certain time period.
People choose adjustable rate loans, because they allow borrowers to lower their monthly payments. Even though there are certain risks that come along with changing interest rates, adjustable rates work great for first time buyers and individuals who plan on increasing their income within the following years. Those with adjustable rate loans can refinance after a few years to a fixed interest rate if they prefer, since they offer more financial security since they will not have to worry about their monthly payment increasing over time.
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