Adjustable rate mortgages ARMs

- [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.