Discretionary ARM

What Is a Discretionary ARM?

A discretionary ARM is a type of adjustable-rate mortgage that allows the lender to change the interest rate at its discretion. Discretionary ARMs are not available in the United States but are common in Europe, Australia, and some other parts of the world.

Key Takeaways

  • A discretionary ARM is a type of variable rate mortgage in which lenders can change the interest rate at any time.
  • Discretionary ARMs are not available in the U.S. but are common in other regions, such as Europe, India, Australia, and Canada.
  • A discretionary ARM, or any variable-rate mortgage, poses a risk to the borrower as rate increases can make the mortgage payments unaffordable.

How Discretionary ARMs Work

As the name implies, lenders can change the interest rates on discretionary ARMs at their discretion, provided that borrowers are informed about the change within a specified period, usually six weeks in advance. 

Frequently, discretionary ARMs offer a short-term introductory interest rate to borrowers, after which the lender may elect to change the interest rate at any time, by any amount, and for any reason. In many cases, there are no caps on the changes lenders can make to discretionary ARMs. In this way, discretionary ARMs tend to be more favorable arrangements for lenders and a potentially risky proposition for borrowers.

Discretionary ARMs and the U.S.

The U.S. is one of the few developed Western nations in which discretionary adjustable-rate mortgages are not available. The adjustable-rate mortgages that are offered in the U.S., often called indexed ARMs, operate differently and provide more protections to the borrower.

Interest rates for indexed ARMs are automated, set by computerized calculations rooted in rules stipulated in the mortgage contract. Under this arrangement, interest rates are adjusted on predetermined dates and are linked to a specific index over which the lender has no direct influence or control.

Additionally, indexed ARMs contrast with discretionary ARMs in that indexed ARMs tend to cap rate changes on any given adjustment date, as well as setting a maximum rate change over the lifetime of the loan. Indexed ARMs may also set a much longer period for the initial interest rate, sometimes running as long as 10 years.

The term adjustable-rate mortgage (ARM) is used more commonly in the U.S. In the English-speaking world outside of the U.S., ARMs are more frequently referred to as variable rate mortgages.

Adjustable vs. Fixed-Rate Mortgages

While adjustable-rate mortgages are in widespread use worldwide, fixed-rate mortgages have traditionally been more popular in the U.S.

Fixed-rate mortgages can be more expensive overall than adjustable-rate mortgages, but they are not at the mercy of changing interest rates. Interest rates remain steady over the lifetime of the loan, which is beneficial to borrowers because they will have a set monthly payment for the lifetime of the mortgage, without any unexpected increases.

In the U.S., fixed-rate mortgages are commonly contracted in 15-year and 30-year increments. While some countries offer some fixed-rate mortgage instruments, in most cases the terms are set for much shorter periods. In France, for example, fixed-rate mortgages can be offered in two-year, five-year, 15-year, and 20-year periods.

Example of a Discretionary ARM

A discretionary ARM may have a low introductory interest rate for a certain period, after which the rate can rise as the lender sees fit.

For example, a borrower might be able to get a rate of 2% for the first two years. After that, the rate might immediately jump to, say, 5% or higher—more than doubling the borrower's monthly mortgage payment. And if the lender so desires, it can raise rates further in the future, as long as it provides proper notice to the borrower. A reputable lender might keep increases in line with prevailing interest rates, but an unscrupulous one is under no obligation to do so.

Pros and Cons of Discretionary ARMs

In some countries, discretionary ARMs are all that lenders offer, so if someone wants to buy a home and lacks the cash to do so, they have no other choice. So the "pro" with a discretionary ARM is that it at least makes borrowing to buy a home possible.

The "cons" center around risk. With any adjustable-rate mortgage, even the kind available in the U.S., interest rate increases can eventually lead to a point where the borrower can no longer afford to make their monthly payments and may even lose their home. This happened during the subprime meltdown that led to the 2008 financial crisis.

Discretionary ARMs can be even riskier, since they may not have any caps on how quickly or how high their interest rates can rise.