The best way to understand an adjustable rate mortgage is to look at a specific example and then, using made-up numbers, examine some variations.
Example: The terms of the loan are as follows. It has a start rate of 2% interest. After six months, the rate changes to 5%. The 5% rate is the rate of the Federal Reserve 11th District Cost of Funds (the index for this example) of 3% plus a 2% margin. The cap is 5%, so you can never pay more than 10% interest. Some lenders will say that the cap is 10% when explaining this loan. Always ask if they define the cap as the total interest that can be required or the amount of the increase. The adjustment period is six months. The adjustment cap is 1%.
Every six months, you must look at the current rate of the index. The interest rate rises or falls by the same amount as the rise or fall of the index rate, up to the cap of 1% per six-month period. This is where the first problem arises. If the interest rate goes up, does your monthly payment also go up? The answer is a definite maybe. Depending on the terms of your specific loan, you may have an increase in your monthly payment that fully reflects the increased interest, partially reflects the increased interest, or does not change at all.
If you owe $300,000, a 1% rise in interest is $3,000 per year. That is $250 per month. This may strain your budget. If your payment increases by less than $250, you are not paying down your loan as quickly as you might have anticipated. If your payment does not increase at all, you could quickly be paying interest only or less (negative amortization). You can voluntarily increase your monthly payments to avoid this, but can you really afford it?
You can easily see that timing is critical for an adjustable loan. If interest rates are at historic highs when you get your loan, your rate will probably adjust downward. An added bonus is that falling interest rates usually cause an increase in property values.
If you use an adjustable loan when rates are at historic lows, you will probably see your rate go up. One problem is that rising interest rates usually cause property values to stabilize or fall. In an extreme case, you would no longer be able to afford to make your increased monthly payment, and falling property prices would make you unable to sell.
The logical question is, “Why would anyone want an adjustable loan when interest rates are low?” The major reason is that it is the only way for them to qualify for a loan. The formula used to qualify a buyer for a loan considers the beginning monthly payment, not the possible future monthly payments. It is similar to the interest only loan situation with the balloon payment. If it is the only way to home ownership, you take the risk.
A more sound reason would be that your job requires you to move every few years. You will pay lower interest and fees for the adjustable loan and you will probably sell before the rates change too much.