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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.

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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.