Adjustment Frequency

What Is an Adjustment Frequency?

Adjustment frequency refers to rate at which the interest rate of an adjustable-rate mortgage (ARM) 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.

Understanding 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 during which the interest rate is fixed, followed by a second phase in which the rate periodically moves 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 Rate vs. Frequency

Adjustment frequency is the rate at which your ARM’s interest rate adjusts periodically. Adjustment rate represents the new rate that you’ll pay for an ARM after each subsequent adjustment period. So again, this may be higher or lower than the initial interest rate associated with an ARM, depending on which way the index or benchmark rate has moved.

As mentioned, ARMs come with built-in rate caps that prevent your rate from increasing unchecked. There are two types of caps: Annual caps and life of the loan caps. The annual cap limits the amount that your rate can change in any given year during the loan term. The life of the loan cap establishes the minimum and maximum rates that you’ll pay for the life of the loan.

What Is the Best Adjustment Frequency?

Generally speaking, a longer adjustment frequency is better for homeowners because it means fewer potential changes to your loan’s interest rate. An ARM whose rate adjusts monthly, for example, could cost you more in interest over the life of the loan compared to an ARM that only adjusts once either every year or every five years.

The best adjustment frequency for an ARM is ultimately one that you can afford, based on your home-buying budget. If you have consistent, stable income and interest rates are generally low across the board, then more frequent rate adjustments may not be as burdensome to your budget. On the other hand, if your monthly payments are fluctuating month over month or year over year, then that could make it more difficult to keep up with your loan obligations.

Adjustment Frequency Example

To demonstrate the consequences of different adjustment frequencies, consider a 5/1 ARM with an initial rate of 3% and an adjustment cap of 1%. This is an ARM that 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%. This results in a new rate of 4% 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%. Assuming that the index rate remains high, the borrower would be forced to pay a 6% rate for six months, while the borrower in the first example would remain at 4% for the entire year. A borrower in the first example would benefit from significant savings.