An adjustable-rate mortgage is also called a variable rate or tracker mortgage. There are two main types of mortgages, one is fixed-rate mortgages, where you pay a fixed interest rate for the duration of the mortgage, and the second is variable rate adjustable mortgage where the interest rate you pay keeps changing when the underlying conditions, like the Fed’s interest rate change.
You can pay less if the interest rate falls and you can also end up paying more if the interest rate rises.
The adjustable-rate mortgages are considered riskier as sometimes; the mortgager would not clearly outline the legally binding agreement. It means that a person is not sure of how his/ her interest payments would change.
In this type of adjustable-rate mortgage, the interest rate is set at the creditor’s discretion. While in the U.S. Adjustable rate mortgages are rare; in the whole world, most of the mortgages are adjustable rate mortgages.
Adjust rate mortgages have also been underlined as the biggest reason for the global financial crisis of 2007-2008.
Poor people who could not afford the houses were tricked into signing up for adjustable rate mortgages and after squeezing everything out of them, their houses were repossessed.
Types of adjustable-rate mortgages
There are two main types of adjustable rate mortgages. These two types of variable rate mortgages are noted in figure 1 given below.
Figure 1: Types of Adjustable rate mortgages
The two main types of adjustable-rate mortgages given in figure 1 are known as interest rate-only mortgages and option mortgages. Each type is further divided into multiple types of an adjustable-rate mortgage.
These types have their own advantages and disadvantages and every person should choose which best meet their needs. These two types of adjustable-rate mortgages are further explained below:
1 Interest-only mortgage
The interest-only mortgages work on the principle that for the first two to three years, the payment only goes towards the interest coverage and not toward the coverage of the principal.
After two or three years, there are two main ways how the interest only mortgages work. First method is the balloon method payment.
In this type of interest only mortgage, after every two or three years, you pay a huge sum of money to the bank or the mortgage holder, until the mortgage is paid off.
The second method of the interest only mortgage is when after two or three years, the monthly payments rise substantially.
The interest only mortgages are not well known, but they are very advantageous. If you are a person who saves a lot, but does not have enough money to put down as equity, you can opt for this type of mortgage.
The interest rate payments are very low and you can save money for two or three years until the balloon payments or monthly interest payments rise are due.
The interest only mortgages are further divided into three types depending on when the adjustable interest rates changes.
7/ 1 adjustable rate mortgage
These are the adjustable rate mortgages which have a fixed monthly payment for the first seven years and after that the interest rate payments keep changing annually.
5/ 1 Adjustable rate mortgages
These are the adjustable-rate mortgages that have a fixed monthly payment for the first five years and after that, the interest rate payments keep changing annually.
One year adjustable rate mortgages
The interest rate of a one-year adjustable rate Mortgage keeps changing every year. You do not know what you would be paying from one year to the next.
2) Option Adjustable-rate Mortgages
The option adjustable-rate mortgages allow the borrower to choose the interest rate. The option adjustable-rate mortgages have a 1-2 percent interest rate.
The teaser rate is the introductory interest rate charged to retain the borrower from the lender.
The interest charges remain same until the value of mortgage changes which means the value of the underlying asset, the house, rises. So, the payments are adjusted.
The option rate adjustable mortgage monthly payments would rise if the value of the house rises. You can also choose to pay big payments at the start so you do not face any issues in the future.
Some other types of Adjustable rate Mortgages
One is a hybrid model of the adjustable-rate mortgage. It is a type of interest-only mortgage, but it also combines the feature of option mortgages.
At the start, adjustable-rate mortgages featuring hybrid characteristics have a fixed payment for multiple years. The number of years can be negotiated.
After the fixed payments expire, adjustable-rate mortgages start charging more monthly payments which depend upon the benchmark interest rates.
The other type is the cash flow adjustable-rate mortgage. It is a form of option mortgage. This allows the borrower to choose from multiple option plans.
After a few years, the borrower can be even opted for minimum payment. This adjustable rate mortgage allows for very high flexibility.
Main advantages of Adjustable-rate mortgages
There are numerous advantages associated with the adjustable rate mortgage. The main advantages of adjustable rate mortgages are as follow:
i) The borrower can expect very low monthly payments.
ii) The borrower can even re-negotiate when conditions are good for lower payments.
iii) The fixed time rate before the adjustable interest rates kick in allow for greater flexibility and also better planning.
4. Main disadvantages of Adjustable rate Mortgages
As there are some advantages associated with adjustable-rate Mortgages, there are also some very big disadvantages, after all, the adjustable-rate Mortgages caused the global financial crisis of 2007-2008. The main disadvantages are as follows:
i) The interest rates charged can be very high.
ii) There is a great discretion given to the lender for charging as much interest rate as the lender can.
iii) The adjustable rate mortgages are highly unpredictable.
Adjustable-rate mortgages can be great or horrible depending upon your need and the type of mortgage you need. So, it is really important to know every detail about the type of mortgage you are getting.