The Adjustable Rate Mortgage

Residential real estate mortgages are issued in a variety of types, as well as for a variety of terms near the end of the decade of the 1990s. The scope in mortgage types and terms, however, was not always the case in the United States. Financing innovations over the past two decades have changed the face of the residential real estate mortgage market (Szerb, 1996). This research examines one innovation in residential mortgage lendingùthe adjustable rate mortgage (ARM).

In the contemporary period, the most prevalent residential mortgage types the are fixed-term/fixed rate mortgage and the ARM. As an example, a 30-year fixed-rate mortgage loan provides for repayment of the loan principal over 360 months at a fixed-rate of interest over the life of the loan. A one-year variable-rate innovative ARM loan, by contrast, may be structured so that it is renewable each year for a 30-year period. At the end of each 12-months, however, the interest rate may be adjusted by the lender in accordance with the mortgage contract. The interest rate is adjusted in accordance with movements in an index that is specified in the mortgage contract, such as the prime interest rate, which is named in the mortgage agreement. Most ARMs contain a capping clause, which limits the amount of the interest rate increase which may be made at the end of any single 12-month period (Dhillon, Saaadu

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borrowers, ARMs in the contemporary period may be customized to meet the needs of specific borrowers (Cotton, 1995, p. 40). Thus, borrower demand has increased for 5/1, 7/1 and 10/1 Treasury-indexed ARMs, which offer "stable monthly payments for five, seven or 10 years and fixed-rate conversion options" (Cotton, 1995, p. 40). Borrowers also may choose "rate-capped and payment-capped ARMs, loans that eliminate closing costs paid by the borrower and mortgages with indexes that lag the more traditional Treasury index" (Cotton, 1995, p. 41). ARM contract typically offer the borrower "some protection from interest rate shocks in the form of rate or payment caps" (Cotton, 1995, p. 40). Such interest rate caps impose both periodic and lifetime ceilings on the interest rate of the underlying mortgage. Typically, these caps limit the interest rate increase in each adjustment period to no more than two-percent, with a lifetime cap of six-percent above the interest rate charged at the inception of the ARM. Interest rate caps provide borrowers the "security of knowing their payments will not climb above a certain predetermined point at each adjustment period or over the life of the loan. Further, borrowers who do not plan to live in t
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