What is an Adjustable Rate Loan?

An adjustable rate loan is a loan in which the rate of interest is variable throughout the duration of the loan. A mortgage is the most common types of adjustable rate loan; it is often referred to as an ARM: adjustable rate mortgage. It may be possible to get an adjustable rate personal loan as well, but this is less common; though credit cards technically do feature adjustable interest rates, they are virtually never referred to as adjustable rate loans.

An adjustable rate loan typically starts with a lower introductory rate; for the sake of example, we will say five percent. Some adjustable rate loans will then have a period of time during which the interest rate cannot increase; this is typically one to five years. After the stable period is over, the interest rate can then adjust. In some cases, it can actually go down based on market conditions; more commonly, however, the rate typically increases. It may increase to 5.25 percent, for instance, or even 6% or more.

An adjustable rate loan will often offer an interest rate cap. For instance, the loan cannot increase more than one percentage point when it adjusts, or it may not be able to increase more than five percentage points for the duration of the loan. These are simply examples, however, and each adjustable rate loan may be different; some adjustable loans will not offer these limitations. After the loan adjusts the first time, it may then adjust every six months to one year after that, and will continue to do so until the loan is paid off.

There are some advantages to an adjustable rate loan. Primarily, the best reason to get an adjustable loan is for the low initial interest rate. Some people then choose to refinance the loan after the initial rate period is over, and get a fixed rate loan instead. This can be a great way to save money over the life of the loan; of course, refinancing is not free, so factor that into the cost of a new loan.

Disadvantages of an adjustable rate loan are somewhat obvious. The loan's interest rate has the potential to increase drastically, which can significantly increase the monthly payment without increasing the amount by which you are paying down the loan. Some people find that it is best to choose a fixed rate loan from the beginning, ensuring that the payment will remain the same for the duration of the loan. The loan holder can then choose to make larger payments to pay off the loan earlier, or to keep the payments the same.