What is an Adjustment Frequency
Adjustment frequency refers to the rate at which the interest rate of an adjustable-rate mortgage is reset once the initial, fixed-rate period has expired. The frequency can significantly add to the interest costs over the life of a loan. A borrower should be aware of this component of their mortgage prior to closing.
BREAKING DOWN Adjustment Frequency
Adjustment frequency is an important but potentially overlooked feature of any adjustable-rate mortgage (ARM). Each ARM features several key variables. These mortgages involve an introductory period in which the interest rate is fixed, followed by a second phase in which the rate is periodically moved to reflect prevailing market rates. Market rates are reflected in an index rate that is identified in the initial mortgage agreement. Initial periods tend to range from three to 10 years. Rate adjustments are limited by caps on the initial and subsequent adjustments. Each ARM will tend to have an absolute rate cap that governs the rate at any point in the life of the loan contract.
Adjustment frequency is most typically set at one adjustment per year. In general, a longer period between rate modifications is more favorable to the borrower. The less often the rate is adjusted, the less often the borrower is exposed to the risk of upward movement in the chosen index. It is important to note that the initial rate of an ARM is typically below the rate of a traditional 30-year mortgage. This helps to attract borrowers to the loan. When adjustments are made more frequently, the lender is able to bring the rate of the loan in line with prevailing rates more quickly.
Adjustment Frequency: an Example
To demonstrate the consequences of different adjustment frequencies, consider a 5/1 ARM with an initial rate of 3 percent and an adjustment cap of one percent. This is an ARM which will have its first adjustment after five years, and subsequent adjustments once a year after the fifth year.
Assume that during the five-year initial period, interest rates have climbed to the point that, at the first adjustment point, prevailing rates are at 6 percent. This results is a new rate of 4 percent for the borrower in the sixth year of their mortgage, with another adjustment to come at the end of that year.
Compare this scenario to a loan with a monthly adjustment frequency. Such a loan would only take three months to climb to 6 percent. Assuming that the index rate remains high, the borrower would be forced to pay a 6-percent rate for six months while the borrower in our first example would remain at 4 percent for the entire year. This would be a significant savings.