Adjustable-Rate Mortgages

By Paul R. Ruedi, CFP®

With the 10-year Treasury making multi-decade highs, mortgage rates are also flying high and tempting people into adjustable-rate mortgages in search of lower interest rates. Unlike a typical fixed rate mortgage that keeps the same interest rate over the entire life of the loan, adjustable-rate mortgages will adjust the interest rate at some point based on how much a benchmark interest rate has risen or fallen.

This effectively shifts the risk of rising interest rates onto the borrower, which is why banks can offer lower interest rates on these loans compared to similar fixed-rate mortgages. They often even provide extra low “teaser” rates in the beginning to entice borrowers. But anyone considering this type of loan should be aware of the key features and risks involved.

It is extremely important to understand when and how much your interest rate can adjust in the future, and you will commonly see adjustable-rate mortgages described with 5 numbers, for example: 5/1 (2,1,4). The first two numbers describe when the interest rate adjusts. The first number represents how long the initial rate is fixed for – in this case the 5 would mean the rate is fixed for five years. The second number is how often the rate adjusts after that initial period. In this case, 1 means it adjusts every year. If there is a 6 there instead, it means the adjustment takes place every 6 months (not 6 years).

The set of numbers in parentheses (2,1,4) describes the caps on how much your interest rate can change. The first number in the series describes how much your interest rate can change after the initial lock-in period, which in this example could be as much as 2%. The second number is the cap on how much your rate can change during subsequent adjustment periods, in this case it can rise a maximum of 1% each adjustment. The final number is the maximum number the rate can change over the life of the loan, in this case 4%.

Adjustable-rate mortgages can be risky, as rising interest rates could increase monthly payments significantly. But this risk could be worth taking for some people. A person may use an adjustable-rate mortgage to stretch their borrowing power if they are reasonably certain their income will rise to accommodate an increase in payments. Borrowers just need to be very aware of when and how much their payments can rise and be certain they will be able to afford it.

Paul R. Ruedi is a Certified Financial Planner™ professional with Ruedi Wealth Management in Champaign, Illinois.