A variable rate loan hooks you with a low interest rate upfront, but you can get into trouble if you’re not aware of just how often that rate will change. The frequency the rate changes on an adjustable mortgage varies by product. You should know the details upfront so you are prepared to handle a sudden change in payment.
Floating vs. Adjustable
The first and most important distinction you need to make is whether you have a floating or adjustable rate loan. Both are tied to an index such as the Wall Street Journal Prime or U.S. Treasury rate. A floating rate loan will change with the index. This means if the index changes every day, your rate can change every day. An adjustable loan is fixed for a set period of time. It will change based on the index on a pre-determined adjustment date. Once it changes, however, it will remain fixed until the next adjustment date. Floating rates are often reserved for lines of credit or construction periods. Adjustable rate mortgages tend to be for home purchases or refinances.
Initial Interest Rate
On an adjustable rate mortgage, known as an ARM, you will have an initial fixed rate. This rate is lower than it would be on a 30-year fixed rate mortgage and is sometimes known as a “teaser rate.” You will enjoy a low rate and the resulting payments until the first adjustment, but you also take the risk that the rate can be significantly higher once the rate fluctuates.
First Rate Adjustment
The timing of the first rate adjustment will depend on the type of ARM you have. The first number in the product states how many years it will be until your first adjustment. For example, a 3/1 ARM will adjust after three years, a 5/1 ARM after five years and so on. ARMs carry both an annual and a lifetime cap. The annual cap limits the amount a rate can rise or fall in one year. The lifetime cap represents the maximum a rate can rise or fall over the life of the loan. It’s important to note that the first rate adjustment is only subject to the lifetime cap. So if your loan is at 5 percent with a 2 percent annual cap and 6 percent lifetime cap, your loan can rise as high as 11 percent at the first rate adjustment period.
Future Rate Adjustments
After the initial rate adjustment, the rate will adjust every year. So, if you have a 5/1 ARM, the first rate adjustment will take place five years after closing and will readjust every year after that. These rate adjustments are subject to both the annual and lifetime cap. So if you have a 2 percent annual cap, your loan can’t adjust more than 2 percent up or down at each rate change. Additionally, if your loan has a 6 percent lifetime cap and it has already risen 5 percent, the next rate adjustment can decrease 2 percent, but it can only increase 1 percent or it will go over the cap.