What Is a Discretionary ARM?

A discretionary ARM is a popular home loan instrument available outside of the U.S.; a variable rate mortgage in which creditors may change interest rates at their discretion. Discretionary ARMs are common in Europe.

Key Takeaways

  • A discretionary arm is a type of variable rate mortgage in which lenders may 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.
  • The lender of a discretionary arm can change the interest rate after a certain period to any amount, within the law.
  • A discretionary-arm mortgage, or any variable rate mortgage, poses a risk to the borrower as it can result in the mortgage becoming more expensive.
  • Variable rate mortgages led to the subprime meltdown that caused the 2008 financial crisis.
  • In other countries, fixed-rate mortgages are offered for shorter terms when compared to the 15-year and 30-year fixed-rate mortgages in the U.S.
  • In the U.S., an indexed-arm mortgage is similar to a discretionary-arm mortgage.

Understanding a Discretionary ARM

A discretionary ARM is a type of adjustable-rate mortgage (ARM) used in Europe, Australia, and other developed countries as a common home loan instrument. The terms of a discretionary ARM dictate that a lender can 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.

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. Instead, adjustable-rate mortgages offered in the U.S. are known as indexed ARMs, which provide more protection 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 predetermined 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 (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.

Discretionary ARMs, Indexed ARMs, and Fixed-Rate Mortgages

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

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

With an adjustable-rate mortgage, the interest rate could climb very high, causing the mortgage to become more expensive. This may lead to a point where the borrower can no longer afford to make their monthly payments. This happened during the subprime meltdown that led to the 2008 financial crisis.

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 that amortize over 25 years, meaning that after five years, the loan balance must be refinanced. In France, for example, fixed-rate mortgages can be offered in two-year, five-year, 15-year, and 20-year periods.