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## Finance and capital markets

### Course: Finance and capital markets > Unit 2

Lesson 3: Mortgages# Adjustable rate mortgages ARMs

Explore the mechanics of adjustable rate mortgages (ARM) in this video, including how they work and in what situation an ARM might be advantageous and when it might work against you.

## Want to join the conversation?

- 1 year treasury what does it relates to ARM? Thanks(13 votes)
- The 1-year Treasury would be used to by the bank to determine your loan rate.

This video discusses what a Treasury is a bit: https://www.khanacademy.org/economics-finance-domain/core-finance/money-and-banking/banking-and-money/v/banking-12-treasuries-government-debt(7 votes)

- What options are present to a bank, in case almost every one of its borrowers are on some fixed mortgage plan and the interest rates have shot way up and have persisted in staying up? In such a scenario, the bank will be getting fixed payments from its borrowers but will be forced to pay out larger and larger money to its lenders. How does the bank keep from going bankrupt?

Is there some practice within the bank to avoid such a scenario? Maybe ensure that a certain percentage of its mortgages are ARMs?(8 votes)- Also, many banks sell their mortgage loans, particularly fixed rate loans, to other financial institutions. Some of these are bundled into a mortgage backed security and sold as an investment.(7 votes)

- If you expect interest rates to be low in the first few years of your loan but high in the last few years, is it worth taking into account that your debt is higher during the first few years, or is that no factor in practice for choosing between ARM and a fixed rate?(4 votes)
- Considering the fact that home loans generally span 15 - 30 years, it's highly unlikely that anyone can predict what the interest rate will be during the last few years of the loan.

Assuming that you somehow have information about the interest rate, extending out 30 years into the future, then yes, it will be quite possible to run a study looking at whether ARMs will be a better investment than fixed mortgages.(14 votes)

- How is the interest rate that gov't pays on treasuries determined? I know how yield and market price is (vaguely though).(4 votes)
- Whatever they gov't can sell the bonds for determines the rate. There are frequent treasury auctions.(4 votes)

- At9:30he starts addressing "Interest Rate Risk" but, isn't he really only looking at who takes on the risk of rates going
**UP**? Who takes on the risk of rates dropping for each type of mortgage?(2 votes)- A fixed rate borrower will take on the interest rate risk for a decrease in rates.

For ARMs, the risk that the short term rate drops in the long term is taken by the lender because they will have to reduce the rate during the next adjustment. This is offset the lender being owed more interest than they otherwise would have gotten for the case that interest steadily drops starting the day after the adjustment period, so it is not as much risk as it is for the borrower in the fixed rate case.(8 votes)

- Once you sing a mortgage either fix or arms. can you pay the monthly payment and pay some more money to cover some more of the principal ?(3 votes)
- Depends on the terms of the loan. Most mortgages allow pre-payment without penalty, but not all.(4 votes)

- But is it possible to have negative interest rates. If yes, then why does it happen?(3 votes)
- think of a negative interest rate as like renting a safety deposit box.

You are paying the bank to keep your money safe.

If you don't like it, you could always spend the money, and improve the economy, which is often the point of negative interest rates.(3 votes)

- Side question from the end of your video. Depositors interest going up? I have never heard it doing that. Doesn't the bank just control that? It seems very unlikely that it could ever significantly affect the difference (by keeping it low) of when the loan interest fluctuates.(3 votes)
- Banks need money to lend.

One way of doing this is by paying interest to savers (depositers).

What the bank is looking to do is get money from me and lend it to my neighbour for a slightly higher rate.

So if the bank offers me 2% interest on my savings account, and can lend the same money to my neighbour for 4%, as long as my neighbour makes the payments, the bank wins.

What if my neighbour wants to borrow more money? Twice as much, say?

well, if the bank offers me 2.5% interest, I might save more, If the bank still lends it to my neighbour at 4%, they have actually made even more money, because although the difference in interest rates is smaller, the bank is now lending twice as much, and in the case I used would expect to make 50% more profit on the money it borrowed from me and lent to my neighbour.(3 votes)

- Give me an example of an ARM rate going down(3 votes)
- As a small update, LIBOR is being phased out by most major banks because it was too easily manipulated.(3 votes)

## Video transcript

- [Voiceover] What I want to
do in this video is explore the mechanics of a typical
adjustable rate mortgage, often known as an ARM, and
then think about and wonder what situations could this be advantageous and in which situations might not this be the best scenario
for the home buyer. So let's just first think
about the mechanics, and to do that I will draw
a little bit of a timeline. Let's say on the vertical axis this is going to be your interest rate, this is in percentage terms. That's one percent, two
percent, three percent, four, five, six and it
can higher than that even. Let's say this is the time axis. This right over here is
the time axis in years. That is one year, two years, three years, four years, five years and maybe
we'll go six years out. Before I even plot the
adjustable rate mortgage, let's think about a fixed rate mortgage. If I had a fixed rate mortgage, it is exactly what the word implies. The rate is going to be fixed. On a fixed rate mortgage,
where the fixed rate mortgages are at the time you get
the loan, based on the type of loan you're getting
and your credit score, let's say you get a
four percent fixed rate. So that means over the life of your loan, your loan is going to
be at a four percent. Whatever you have to
pay on your principle, whatever principle you
have left over every period you will pay an equivalent of
a four percent annual rate. And we've gone into some
depth on that in other videos, where we talk about 30 year and 15 year and 10 year fixed mortgages. And you might be saying "Wait, I thought "as time goes on I pay down
more and more principle, "which means that each of my payments, "less and less of it goes to interest. "So it doesn't feel like
my interest is changing." And there's truth to
that, the dollar amount that you're paying towards interest with a traditional fixed
rate mortgage does go down every month as you pay down
more and more principle. But the interest rate, the
rate that you're paying on the principle that you have remaining, is going to be constant. In this example, it would
be a constant four percent. Now what about an
adjustable rate mortgage? As you can imagine, that means that the mortgage is going to adjust. So an adjustable rate mortgage
might start at two percent, and that might look really good, but the way that the deal will work is, if short term interest
rates were to increase, the adjustable rate mortgage
will increase as well. So there could be a reality where if short term interest
rates increase enough, the adjustable rate mortgage
interest rate, or rate, might be even higher than
the fixed rate mortgage. And if interest rates were
to go dramatically higher, that depends on if there are caps in place and whatever else, this rate
could grow dramatically higher. What do I mean by all of that? And what do I mean by "What if short term interest
rates were to go up?" When you have an adjustable rate mortgage, it usually adjusts to some index rate. In the US the most typical
one is short term Treasuries. That's the rate that the
government has to pay when the government wants
to borrow money for a year. So one year Treasuries, although there could be other underlying indexes. Another very typical index for any type of adjustable rate loan,
not just mortgages, but any type of loan,
even corporate loans, could be the London Interbank
Offered Rate, LIBOR. London Interbank Offered Rate, and we have other videos on what LIBOR is. Let's just say that we're
dealing with one year Treasuries as the underlying index. One year Treasuries, there's
a market for Treasuries, so that just changes with the day. Let's say this is the plot of what happens for one year Treasuries over time. So this is the rate, so
this means that right at this period of time, if you were to lend the government money for a year, you're going to get two percent. The government's borrowing
rate is two percent. Now, it's very unlikely that any lender will give you the exact
same rate as the government. The government can print
money, you have the full faith and credit of the United States. So you don't have that when you're paying, you might get into financial
difficulty, you might not be able to pay your loan for some reason. So you're not going to get that
exact rate, you're gonna get that rate plus some premium. Let's say you have pretty good credit, so let's say the premium
is only one percent. A premium like one
percent, that's actually what even very, very well
established companies would get. This is just to make the math easy. You see that right over here, the time that the loan was issued,
the one year treasury was like one percent, and so
you're gonna get a two percent. The way that an ARM works is, at some period, sometimes
it'll be every six months, sometimes every year,
your rate will be reset. So let's say we're dealing with
an adjustable rate mortgage and it resets every year. So yearly adjustment in the
case that we're looking at. So that means you're
gonna pay your two percent for the first year, from time zero to one year going by. And then at that point,
they're going to look at what the underlying
index is, and it's like "Okay, the index now looks like it's "at about one point six percent." So you're gonna pay a one
percent premium over that, so you're gonna pay two point six percent. So you're gonna pay two point
six percent for the next year. Now short term interest
rates have gone up even more. Looks like they're pretty close to three, so now you're gonna pay
four percent interest. So in this scenario where interest rates have steadily gone up, your mortgage rate is adjusting every year up. You see by at least this
third year, you are paying roughly the same as if you had
gotten a fixed rate mortgage. Now you might be saying "Hey, but it's still been a good deal. "I've paid for the first two years lower "than I would have paid
on a fixed rate mortgage. "And then only in the third
year I'm paying the same." And that's true, for this scenario, that so far has worked
out pretty well for you. But then in year three,
interest rates are even higher, so it would adjust even higher. So your adjustable rate might be up here. In this year you're actually paying more, your interest rate, the rate
of interest on the principle that you owe on your house, is now more than your fixed rate mortgage. Then I draw a scenario
where all the sudden it becomes more favorable
again, so it might adjust down. So here you're still paying
more than you would pay in your fixed rate, but then by this year, you're now paying less again. This is just one of many scenarios. In this one you're like "Okay, you know adjustable rate mortgage, "maybe this might have worked
out more years than not. "I'm paying less than I would have paid "with the fixed rate mortgage."
Lower rate I should say, there's only a couple of years here. But you have to remember, this is just one of
many possible scenarios. Maybe inflation goes
crazy, or whatever else, and maybe this index
does something like this. Which isn't typical, it's
not likely to happen, but things like that
have happened in history, when you had large inflationary periods. In something like this, all of a sudden you can see your adjustable rate mortgage adjusting up by a good bit. There's often these things called caps in place that keep the
mortgage from adjusting more than a percent or
two percent per year. But if you saw something like that, or if you saw something that just went straight
like this, that means that over the life of your loan, especially if your loan goes
out 10 or 15 or 30 years, you could end up paying a
substantial amount more interest. On the other hand, it's
completely possible that interest rates do
this the entire time. In which case, the
adjustable rate mortgage might work out better. So you might be noticing a pattern here. With your fixed rate mortgage,
it's very predictable. You can predict this, so the
payment that you're making from one month to the next,
even if it's interest only, whatever payment you're making, whatever interest rate,
it is not going to change. While the adjustable rate
mortgage it is less predictable. This brings up a very interesting idea, called interest rate risk, which you might sometimes
hear people talk about on the cable finance
networks and whatever else. Or if you're reading the financial section of the newspaper, interest rate risk. This is just the risk that you take on if interest rates were
to change dramatically. If you have an adjustable rate
mortgage, what's your risk? The interest rate risk you're taking on is "What if interest goes up a lot?" Then your payment goes up. With a fixed rate mortgage, who takes on the interest rate risk? With a fixed rate mortgage, the bank takes on the interest rate risk. Let me write this down, this is an ARM, and this right over here is the fixed. Who takes on the interest
rate risk in the ARM scenario? The borrower does. They might get the benefit of lower rates, but if rates were to go up dramatically, the borrower takes on this risk. While in the fixed rate,
who takes on the risk? In this scenario it's
going to be the lender. Why is the lender taking on a risk? If they lend something to
you at a fixed interest rate, let's say this four
percent, and if interest were to go up dramatically,
remember many lenders, especially financial
institutions like banks, they are borrowing money as well. Who are they borrowing money from? They could be borrowing from
a whole bunch of sources. One of them is the people
who are keeping deposits. Remember what a bank does. If this is the bank right over
here, people give deposits, and we go into much more
detail in other videos, and then it is loaned out. When they take deposits,
they are often times promising people interest and when they issue loans they're getting interest as well. This is fixed, right over here, but if short term interest
rates were to go up, then they're going to be paying
more than they're getting. Or this is not changing,
while this is going up, so they're not going to
be making as much money. So the risk, adjustable rate
mortgage, borrower takes on, the fixed rate, the lender takes on.