Adjustable rate mortgages ARMs | Housing | Finance & Capital Markets | Khan Academy

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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 under what situations this could be advantageous and in which situations it might not be the best scenario for the home buyer. So let's just first think about the mechanics. To do that, I will draw a little bit of a timeline. - On this axis right over here on the horizontal axis, or sorry, on the vertical axis, this is going to be your **interest rate** (in percentage terms). So maybe that's 1%, 2%, 3%, 4%, 5%, 6%, and it could go higher than that even. - Here, let's say this is the **time axis** in years. So, time in years: 1 year, 2 years, 3 years, 4 years, 5 years, and maybe we'll go 6 years out. Before I even plot the adjustable rate mortgage, let's think about a **fixed rate mortgage**. A fixed rate mortgage is exactly what the word implies: the rate is going to be fixed. So, on a fixed rate mortgage, maybe 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 **4% fixed rate**. This means over the life of your loan, your loan is going to be at a 4%. Whatever principal you have left over, every period you will pay an equivalent of a 4% annual rate. We've gone into some depth in that in other videos where we talk about 30-year, 15-year, and 10-year fixed mortgages. You might be saying, "Wait, I thought as time goes on I pay down more and more principal, which means that each of my payments, less and less of it goes to interest." 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 principal. But the interest rate, the rate that you're paying on the principal that you have remaining, is going to be constant. In this example, it would be a constant **4%**. Now, what about an **adjustable rate mortgage**? As you can imagine, that means that the mortgage is going to adjust. An adjustable rate mortgage might start at **2%**, 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 might be even higher than the fixed rate mortgage. If interest rates were to go dramatically higher, and depending if there are caps in place, this rate could grow dramatically higher. What do I mean by all of that? When you have an adjustable rate mortgage, it usually adjusts to some index rate. In the U.S., the most typical one is **short-term treasuries**—that's the rate at which the government has to pay when it wants to borrow money for a year. Although there could be other underlying indices, another very typical index for any type of adjustable rate loan, not just mortgages but any type of loans, even corporate loans, could be the **London Interbank Offered Rate (LIBOR)**. Let's just say that we're dealing with one-year treasuries as the underlying index. One-year treasuries have a market, and so that just changes with the day. Let's say this is the plot of what happens for one-year treasuries over time. This is the rate, which means that right at this time period, if you were to lend the government money for a year, you're going to get **2%**. The government's borrowing rate is **2%**. 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, and you might not be able to pay your loan for some reason. So, you're not going to get that exact rate; you're going to get that rate plus some premium. Let's say you have pretty good credit, so let's say the premium is only **1%**. This is just to make the math easy. So, let's say at the time the loan was issued, the one-year treasury rate was **1%**, and so you're going to get a **2%**. The way that an ARM works is that at some period—sometimes it'll be every six months, sometimes every year—your rate will be reset. Let's say we're dealing with an adjustable rate mortgage that resets every year. So, yearly adjustment. This means you're going to pay your **2%** for the first year, from time zero to one year. Then, at that point, they're going to look at what the underlying index is, and it's like the index now looks like it's at about **1.6%**. So, you're going to pay a **1%** premium over that, meaning you're going to pay **2.6%** for the next year. Now, short-term interest rates have gone even more up; it looks like they're pretty close to **3%**, so now you're going to pay **4%** interest. In this scenario where interest rates have steadily gone up, your mortgage rate is adjusting every year. By this third year, you are paying roughly the same as if you had gotten a fixed rate mortgage. 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 the fixed rate mortgage, and then only in the third year I'm paying the same." 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. Your adjustable rate might be up here, and in this year, you're actually paying more. Your interest rate on the principal that you owe on your house has now become more than your fixed rate mortgage. Then I draw a scenario where all of a sudden it becomes more favorable again, and so it might adjust down. Here, you're still paying more than you would pay in your fixed rate, but then by this year, maybe right over here, 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." There are only a couple of years here, but you have to remember this is only 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 during large inflationary periods. In something like this, all of a sudden, you could see your adjustable rate mortgage adjusting up by a good bit. Now, there are often these things called **caps** in place that keep the mortgage from adjusting more than **1%** or **2%** 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**, **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. You might be noticing a pattern here: with your fixed rate mortgage, it's very predictable. This is 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, is not going to change. While the adjustable rate mortgage 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 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. So, 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. Now, with the fixed rate mortgage, who takes on the interest rate risk? In the fixed rate mortgage scenario, it's going to be the lender. Let me write this down: - **ARM**: The borrower takes on the interest rate risk. They might get the benefit of lower rates, but if rates were to go up dramatically, the borrower takes on this risk. - **Fixed Rate**: The lender takes on the interest rate risk. Why is the lender taking on a risk? If they lend something to you at a fixed interest rate, let's say this **4%**, and if interest were to go up dramatically, remember many lenders, especially financial institutions like banks, are borrowing money as well. Who are they borrowing money from? They could be borrowing from a whole bunch of sources, but one of them is the people who are keeping deposits. Remember what a bank does: - People give deposits, and then it is loaned out. So, when they take deposits, they are usually promising people interest, and when they issue loans, they're getting interest as well. Now, if 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. In summary, with an adjustable rate mortgage, the borrower takes on the interest rate risk, while with a fixed rate mortgage, the lender takes on the interest rate risk.

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