What is a Discretionary ARM

A Discretionary ARM is the primary home loan instrument available outside of the U.S., a variable rate mortgage in which creditors may change interest rates at their discretion.

BREAKING DOWN Discretionary ARM

A Discretionary ARM is a type of adjustable rate mortgage used in Europe, Australia, India and other developed counties as a primary home loan instrument. The terms of a discretionary ARM dictate that a lender is able to change the interest rate of the mortgage at their discretion, provided that borrowers are informed about the change in interest rate within a specified period, usually six weeks.  

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, 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. In most cases, countries with offer discretionary ARMs do not offer other forms of mortgages, including fixed-rate mortgages and indexed ARMs.

The U.S. is one of the few developed Western nations in which discretionary adjustable rate mortgages are not available. Instead, adjustable rate mortgages offered in the U.S. are known as Indexed ARMs, which provide more protections to the borrower.

Interest rates for indexed ARMs are automated, set by computerized calculations rooted in rules stipulated in the ARM contracts. Under this arrangement, interest rates are adjusted on pre-determined dates and adhere 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 also tend to set a much longer period for the initial interest rate, sometimes running as long as 10 years.

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

Discretionary ARMs, Indexed ARMs, and Fixed-Rate Mortgages

While adjustable-rate mortgages are in widespread use worldwide, the U.S. Federal Housing Administration was instrumental in establishing the fixed-rate mortgage as one of the most popular financial instruments for purchasing property in the U.S.

Fixed-rate mortgages tend to be more expensive overall than adjustable-rate mortgages, and they are not at the mercy of changing interest rates and the interest rate remains steady over the lifetime of the loan. 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. Standard mortgage periods in Canada, for instance, are five-year mortgages which amortize over 25 years, meaning that after five years, the loan balance must be refinanced.