An adjustable-rate mortgage is a loan in which the interest rate can change over time. The loan contract will specify the limits within which the rates can change, when the rates can change and what will determine the new rate. As a rule, the rate will be held stable for the first year or so of the loan.
As a rule, when the rate adjusts, it will be set by some formula, such as prime rate plus 3% or LIBOR plus 5% or whatever it might be. The prime rate is the amount charged by a specified major bank to its best customers. LIBOR is an index of interest rates charged by banks on the London, Britain exchange. You can obtain up to date information on various prime rates, LIBOR and the other indexes in the Wall Street Journal or other financial publications.
Adjustable-rate mortgages can be very dangerous to borrowers. Unscrupulous lenders will often offer an extremely low initial rate – called a teaser rate –, which will then adjust upwards a great deal after a year or two. It often happened, during the recent real estate boom, that a buyer with bad credit would be offered an extremely low initial rate, upon which he or she could barely make the monthly payments. Then, after a year or two, the interest rate would adjust upward so much that the monthly mortgage payment would double or triple in amount, making foreclosure virtually inevitable unless the property was sold or re-financed. As long as prices continued to go up rapidly, this approach could work out, because the property could be sold for a higher figure than the purchase price. Once prices stopped rising, however, and particularly when they started to fall, this type of loan was a recipe for disaster.
The advantage of adjustable-rate loans is that the rates offered can be lower than those of fixed rates. If, for some reason, you are sure that you do not intend to keep the property, or the loan, for more than a few years, a lower-cost adjustable loan could make sense for you. If you intend to keep the property, or the loan, for any length of time, then adjustable rate loans are very dangerous.