Adjustable-Rate Mortgage (ARM)

  

Categories: Metrics, Tax, Bonds, Real Estate

The key letter in ARM is A, and it stands for adjustable, as in Adjustable Rate Mortgage.

Most mortgages have a fixed interest rate. That means you pay 5% interest (or whatever your rate is) during the first year you have your mortgage, during the third year, and all the way to the final day you have that loan and can throw your big ""We Paid it Off"" party.

With an adjustable rate mortgage, your rate can change. Why would you want to get an ARM rather than a fixed rate mortgage? Well, maybe you like the element of surprise. More likely, you can save a few bucks at the start of the mortgage loan. If interest rates are expected to rise, you can get a better rate (at first) with an ARM than you can with a fixed rate mortgage. By the time your ARM rates go up and you have to pay more, maybe you'll have gotten that promotion at work.

Lots of folks choose ARMs, because they seem like a better deal on paper, but you'll want to run side-by-side comparisons to figure out whether they'll cost you more in the long run. You'll also want to make sure you can afford your home loan—even if interest rates go up. If you're just barely making payments now and your monthly mortgage costs go up $300, what are going to do? That's the sort of situation that causes people to lose their homes.

ARMs have a couple parts. They usually start with a low interest rate and have a guaranteed period of time for that interest rate, so you know your interest rate won't go up right away. An ARM also usually comes with an index (like LIBOR) against which it is adjusted, a step up percentage (how much the interest rate will likely grow each period), and maybe a cap (the maximum rate it can be raised in a given period). That all ensures that the rate won't balloon out of control.

Some ARMs are interest-only for the first few years. The monthly amount you pay is really low, but you're also not paying down the principal or the amount you borrowed. Which means the total amount you owe to the bank is not going down any. The upside is that your payments will be affordable at first, and you'll have time to increase your income or get a great job (and hopefully give interest rates a chance to drop).

Related or Semi-related Video

Finance: What is Adjustable Rate Preferr...15 Views

00:00

Find it a la shma What is adjustable rate preferred

00:06

stock Okay let's start with the basics preferred stock and

00:11

yes we have a whole video on this one as

00:12

well Preferred stock generally pays a dividend and is often

00:17

convertible into common stock at a premium to where it

00:21

was issued So preferred stock is kind of bond like

00:26

and kind of equity Like fish Most preferred stocks get

00:30

issued some set dividend like a base rate of say

00:33

six percent or something like that And note that it's

00:36

called a dividend in the case of preferred stock not

00:41

an interest payment subtle but very important difference here because

00:45

interest on bonds is tax as ordinary income and dividends

00:49

on equities are qualified meaning that their tax at long

00:54

term gains rates or dividend tax rates anyway these preferred

00:58

pay six percent no matter what the price at which

01:02

one preferred unit trades will fluctuate like a stock or

01:06

bond But that thousand dollars par preferred will just continue

01:11

to pay its sixty bucks a year in dividends until

01:14

the preferred shares are bought back by the company you

01:17

know at some premium or until the shares convert into

01:20

being common stock or the company goes bankrupt in armageddon

01:24

scenario one starring ben affleck jr But in the case

01:28

of adjustable rate preferreds it's not always the six percent

01:32

that gets paid or whatever the initially stated rate wass

01:36

in the case of these equities and yes preferred stocks

01:39

considered equity even though it acts like a bond Sometimes

01:42

in this case the dividends will very with some set

01:45

indexed like t bills or live or where the preferred

01:50

dividend might be set on a say a trailing four

01:53

quarter bases to be two hundred basis points Mohr interest

01:58

that it pays than the average t bill reign as

02:02

of blah blah blah blah time frame Well why would

02:05

you want this adjustable feature with preferreds Well you can

02:09

imagine a scenario in a low interest rate environment where

02:13

we have preferred stocks paying five percent and the prevailing

02:16

rates are three percent for very high quality dead teo

02:20

top notch blue chip companies But then we get inflation

02:25

and that three percent for the best borrowers goes to

02:28

six percent and a given preferred stock would then need

02:32

to pay more like eight percent to be trading around

02:35

The thousand dollars par value it was issued at So

02:38

said another way if that piece of paper is on

02:41

ly giving investors fifty bucks a year when a very

02:45

similar piece of paper gives investors eighty bucks a year

02:49

investors will want charity They will sell down than thousand

02:54

dollar piece of paper giving only fifty bucks to price

02:57

low And so that when it's bought it pays eighty

03:02

bucks a year in charity right that thousand dollars going

03:05

to sell down to nine hundred eight hundred seven hundred

03:08

until whatever you pay for it pay the same interest

03:10

rate is that eighty dollars year thing Thank you Inflation

03:13

specifically In this case a thousand dollars preferred paying fifty

03:17

bucks a year would have to sell for six hundred

03:21

twenty five bucks teo yield eight percent meaning that the

03:26

thousand dollars par value that investors bought in a five

03:29

to ten years ago would drop dramatically by three hundred

03:32

seventy five dollars a unit to be six hundred twenty

03:36

five dollars To be quote at market unquote and that's

03:40

a problem a big risk that investors will hate Hence

03:44

the invention of the adjustable feature here Adjustable rate preferred

03:49

Stock Great inventions So in this case if it preferred

03:53

was adjustable if rates went up a cz were describing

03:56

here then it is extremely likely that the t bill

04:00

or live or rates would go up similarly as they

04:03

generally follow inflation grids over time And in this scenario

04:08

if the rate of the dividend on the preferred stock

04:11

at just's then it's always going to be something like

04:15

t bill ray plus three hundred basis points or something

04:18

like that so that if there really is big inflation

04:22

and federal funds rates go from three percent to six

04:25

percent The return on these preferreds would go up about

04:29

the same amount making the security much more appealing to

04:33

investors Got all that well let's Just hope that if

04:36

anything else is in need of getting adjusted those investors

04:39

will take care of it in private nia do that

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