How Do Adjustable Rate Mortgages Work

How Do Adjustable Rate Mortgages Work

Last Updated 12/11/2014

There are two main types of mortgages: fixed and adjustable. Fixed mortgages are fairly straightforward. You take out a loan and your monthly payments stay the same during the entire loan. Adjustable rate mortgages are a little more complicated because your monthly payments can change over time. It’s important to understand exactly how do adjustable rate mortgages work before taking one out so you don’t bump into any surprises.

How Do Adjustable Rate Mortgages Work

Starting Out

Most adjustable rate mortgages have an initial period where they keep the monthly payments the same. This initial period usually lasts somewhere between one to five years. The monthly payments on an adjustable rate mortgage also start out lower than the payments on a fixed mortgage for the same amount of money. However, while a fixed mortgage always keep the same monthly payments, the payments on an adjustable rate mortgage can change after this initial period.

How Payments Can Change

Once the initial period ends, your lender could change the monthly payments on your adjustable rate mortgage. The lender will base this change on market interest rates. If rates have gone up, your monthly mortgage payments will go up. If rates have gone down, your monthly payments will go down. Some loans adjust payments every month while others adjust only once a year or once every several years. The important thing is to keep in mind that your payments can and will change so don’t assume everything will stay the same with your loan.

Limit on Adjustments

There are some limits on how much an adjustable rate mortgage can change. This keeps payments from going up too quickly and putting homeowners in a tough spot. Loans usually have a limit to how much the interest rate can change both per adjustment period and over the entire loan.

For example, if your mortgage adjusts every year, it might set a cap where the interest rate can go up by no more than 2% every year and never go more than 6% higher of your original interest rate. By asking your lender about these limits, you can estimate just how much your adjustable rate mortgage could end up costing you in a worst case scenario.

While the payment structure of an adjustable rate mortgage is a little more complicated than a fixed mortgage, that shouldn’t scare you away from considering this type of loan. With this information, you’ll be in good shape to evaluate this type of mortgage and decide whether it’s the right product for buying your new home.