# Adjustable rate mortgages ARMs | Housing | Finance & Capital Markets | Khan Academy

In this video I want to look the mechanisms of a typical floating rate mortgage, also known as RLP (Adjustable Interest Rate), and then to think in what situations it would be useful and in what it may not be the best option for a home buyer. Let's just think about the mechanism first and to do that, I'm going to draw a little timeline.

Let's say the vertical axis will represent the interest rate, that is, in percent. That's one percent, two percent, three percent, four, five, six, and maybe even more than that. Let's say this is the time axis. This here is the time axis in years. This is one year, two years, three years, four years, five years and maybe we'd break up in six years. Before I build the floating rate mortgage chart, to consider a mortgage with a fixed interest rate. If I had a fixed rate mortgage, would mean exactly what the word itself implies.

The interest rate will be fixed. In the case of a fixed-rate mortgage, the fixed-rate mortgage is as follows: at the time you take the loan, according to depends on what kind you take a loan and what is your credit history, let's say you get an interest rate of four percent. This means that for the time the loan is running its interest rate will be four percent. What you have to pay in installments, what installment you have left after each time period you will have to pay her four percent in annual interest.

We've looked at it in more detail in other videos, in which we talk about 30- and 15-year-olds and 10-year fixed mortgages. Maybe you're saying, "Wait, I thought I would pay more and more on the principal over time, which means less and less from each installment goes to interest. That is, the interest rate does not seem to change. " And there is truth in this – the amount which you pay at interest with a fixed rate mortgage really decreases each month by paying more on the principal. But the interest rate, the rate you pay on the remaining principal remains constant. In this example, we will use a constant interest rate of four percent. And now what about the floating rate mortgage? As you think, that means that the mortgage will be recalculated.

That is, a floating rate mortgage can start at an interest rate of two percent, which would look pretty good, but the way this deal works is: if short-term interest rates rise, a floating rate mortgage will also rise. There is a reality in which if short-term interest rates rise sufficient, the interest rate on the recalculated mortgage may be higher than that of a fixed rate mortgage. If interest rates rise significantly, according to depends on whether there are ceilings at some rates, this interest rate can increase a lot. What do I mean here? What is the point of saying "What happens when short-term interest rates rise?" When you have a floating rate mortgage, it is usually adjusted to some base interest rate or index.

In the United States, the most common is short-term treasury bills. This is the interest rate you need pay the government when it wants to borrow money for a year. That is, we have one year of treasury bills, though there may be other subject indices. Another typical index for any species floating rate loans, not just mortgages, but any type of loan, even corporate, is the London interbank interest rate, LIBOR. London interbank interest rate and we have other videos about what LIBOR is. Let's just say we're looking at annuals treasury bills such as the subject index.

One year of this index and there is a market for it, therefore it changes daily. Let's say this is the graph of what is happening over time with one-year treasury bills. This is the interest rate, which means that if in exactly this period of time lend money to the government for a year, will you get interest – two percent. The interest rate on the government loan is two percent. It is very unlikely that any lender will be to offer you the same interest rate as that of the government. The government can print money, you have faith and trust in the United States. However, the bank does not have them in you, when the payer – you may find yourself in financial difficulty due to some reason you can't pay the loan. That's why they won't offer you the same interest rate percentage, and will add to it a premium. Let's say your credit history is good, so your premium is one percent. In fact, only well-established companies would receive a premium of only one percent. We do it to facilitate the calculations.

You see this here – in time, in which you took the loan, the one-year treasury bills were interest of one percent and so now you will pay two percent. The idea of ​​a mortgage with RLP is over a period of time, sometimes every six months, sometimes every year, the interest rate is recalculated. Let's say we have a floating rate mortgage that is recalculated each year. That is, the case we are considering is the recalculation of interest rates each year. This means that you will pay two percent interest in the first year, from the beginning of the timeline until the first year. And at this point they will look what is the subject index and they will say to themselves: "It looks like the index is now is equal to 1.6 percent.

" Then you will pay one percent in premium to the index, which equates to 2.6 percent. In short, you will pay an interest rate of 2.6 percent for next year. But now short-term interest rates have risen even higher. Pretty close to three, therefore you will pay an interest of 4 four per cent. In a scenario in which interest rates rise constantly, the interest rate on the mortgage is recalculated every year. Now you see that you will pay by the third year at the earliest approximately the same interest rate as on a fixed interest mortgage. You may be thinking: "Hey, that's a good deal. The first two years I paid less than I would pay at a fixed interest rate. And only for the third year I will pay the same amount. And this is true in this case – for now the bills are in your favor. But now in the third year interest rates are even higher and the interest rate will become higher.

Therefore, the interest rate may be up here. You pay more this year – your interest rate, the interest you pay on the installment on the house is now more than the interest of the fixed rate mortgage. Now I drew a case in which suddenly the situation is more favorable and the interest rate will be lower. You still pay more here than you would at a fixed interest rate, but this year already again you pay less. This is one of the many cases and in it you think: "But again the mortgage with an interest rate rather, it was in my favor for most of the years. I pay less than I would in the case of a fixed rate mortgage. "I must say that is lower only a few years. But remember, that this is just one of many possible cases. Maybe either inflation is out of control or something else and then something similar happens to the index.

However, this is not typical, it is unlikely to happen, but such things have happened before during huge periods of inflation. In such a case, it can suddenly the floating interest rate on your mortgage to rise by a lot. So-called ceilings are common, which protect the mortgage from recalculation by more than one or two percent per year. But if you see something like this or something like that goes straight this way, that means that for the life of the loan, especially if it lasts 10 or 15 or 30 years, you can pay a significantly higher amount of interest. On the other hand, it is entirely possible interest rates to look like this all the time, and in this case the floating rate mortgage it may turn out to be much better. You are probably already noticing a trend here. It is quite predictable with a fixed rate mortgage. You can predict it and therefore what you pay for a month for another, even if only on interest, whatever contribution you make, no matter the interest rate, it will not change. However, while the mortgage with a floating interest rate is less predictable.

This brings us to a very interesting idea, called interest rate risk and it's something you can hear people talking about, when the topic is the financial networks of the exchange rate between the pound and the dollar. You can also find it when you read the financial section of the newspaper. This is the risk you take in the event that interest rates change dramatically. What is your risk with a floating rate mortgage? The risk you take is "What if interest rates go up a lot?" Then the payment amount goes up. In the case of a fixed interest mortgage, who bears the risk to interest rates? In the case of a fixed interest mortgage, the bank takes the risk. Let me write it – this is RLP and this here is the fixed interest rate. Who bears the risk to the interest rate in the case of a floating rate mortgage? The borrower takes the risk. Will benefit from lower interest rates, but if interest rates rise sharply, then the borrower takes the risk.

And who takes the risk at a fixed interest rate? In this case, it will be the lender. Because he takes the risk? If you are granted a fixed rate loan, let's say four percent, and if interest rise significantly … Remember that many lenders mostly financial institutions such as banks also borrow money. From whom do they borrow money? They can borrow money from many sources. One of them is the people who keep the deposits. Remember what the bank is doing. If this is the bank where people make deposits … And we delve much deeper into other videos … The money is then given as loans. When taking from deposits, quite often promise interest to the people and when the bank grants a loan, she also receives interest. This here is a fixed interest rate … But if short-term interest rates rise, then the bank pays more than it receives. Or this does not change here, and this rises and so the bank will not make that much money. The risk of floating interest is borne by the borrower, and at a fixed interest rate – by the lender..