Mortgage Comparison
Fixed and Adjustable Rate Loans on the Exam
Rate levels, index values and the specific structures lenders offer change constantly. Learn the mechanics below, and use whatever figures an exam item supplies rather than any number you have memorized from the market.
One loan locks its rate for the whole term. The other resets it on a schedule using a formula written into the note. Almost every exam item on this pair is really asking whether you can run that formula.
Work through the adjustable side carefully. Fixed-rate loans are tested in a sentence or two; the caps, the index and the margin are where the questions and the wrong answers live.
The Distinction in One Paragraph Each
On a fixed-rate loan the note rate is set at closing and never moves. The principal and interest portion of the payment is identical in the first month and the last, which makes the loan trivially easy to budget against. Any change in the total payment comes from escrowed taxes and insurance, not from the loan itself. The borrower carries no interest-rate risk after closing; the lender carries all of it.
On an adjustable-rate loan the note fixes the rate only for a stated opening period, after which it is recalculated at set intervals from a published benchmark. The borrower usually gets a lower opening rate in exchange for accepting that recalculation. Interest-rate risk sits mostly with the borrower, bounded by whatever limits the note contains.
The exam reasoning is a matter of holding period and rate direction. A borrower who intends to hold the property for a long time, or who is borrowing when rates are low, benefits from locking. A borrower who expects to sell or refinance before the first adjustment, or who is borrowing when rates are high and expected to fall, may rationally take the adjustable opening rate. Items give you the borrower's plans for exactly this reason.
The Vocabulary Items Are Built From
Every adjustable-rate question is assembled from these parts. Know what each does and you can answer items you have never seen.
Index. A published benchmark rate that the lender does not control and cannot set. It moves with the market, and it is the moving half of the rate calculation.
Margin. A fixed number of percentage points the lender adds to the index. It is written into the note at closing and stays put for the life of the loan. When a question describes something about the rate that never changes on an adjustable loan, this is usually the answer.
Fully indexed rate. Index plus margin, calculated as of an adjustment date. This is the rate the loan is heading toward, and it is what you compute first on any adjustment item.
Introductory rate. A below-formula opening rate used to make the early payments attractive. Because it sits below index plus margin, the first adjustment moves the rate up even in a market where the index has not moved at all.
Periodic cap. The most the rate may move at any single adjustment, up or down. It limits the size of one step, not the total distance traveled.
Lifetime cap. The ceiling over the whole term, generally expressed as a number of points above the starting rate. This is the borrower's worst case, and items ask for it directly.
Adjustment interval. How often the recalculation happens once the opening period ends. A loan described with two numbers gives the opening fixed years first and the interval between later adjustments second.
Payment cap. A limit on how far the payment amount may rise, which is not the same thing as a limit on the rate. This distinction is the setup for negative amortization items.
Running an Adjustment, Step by Step
Adjustment questions look harder than they are because they ask you to apply two constraints in the right order. Use the same four steps every time.
Step one: add the index value the item gives you to the margin from the note. That is the fully indexed rate, which is where the loan wants to go. Step two: check the periodic cap. Take the current rate and add the cap; if the fully indexed rate is above that number, the rate stops at the capped figure and the rest waits for the next adjustment. Step three: check the lifetime cap by adding it to the original starting rate; the loan cannot exceed that figure whatever the index does. Step four: the new rate is the lowest of the fully indexed rate, the periodic limit and the lifetime ceiling.
A generic run-through: a loan opens at four percent with a margin of two and a half points, a periodic cap of two points and a lifetime cap of five points. At the first adjustment the index reads three and a half. Fully indexed is six. The periodic limit is four plus two, or six. The lifetime ceiling is four plus five, or nine. The lowest of the three is six, so the rate becomes six percent. If the index had instead read five, fully indexed would be seven and a half, the periodic limit would still be six, and the rate would adjust only to six with the remainder deferred.
Two habits keep you out of the distractors. Apply the periodic cap to the rate currently in force, not to the original rate, and apply the lifetime cap to the original rate, not to the current one. Reversing those two is the single most common error on the topic, and test writers price in that mistake by including the wrong answer it produces.
The Two Risks Items Keep Coming Back To
Payment shock
The jump when a below-formula opening rate expires and the loan repositions at index plus margin. The borrower qualified against a payment that was never the real payment, and the increase arrives in one step at the first adjustment. Items describe a borrower who is comfortable for a couple of years and then is not; the reasoning they want is that the opening rate was an inducement rather than the loan's actual pricing.
Negative amortization
When the required payment is less than the interest accruing, the shortfall is added to the balance rather than forgiven, so the debt grows while payments are being made. It arises where the payment is capped but the rate is not, so the payment cannot keep up with the interest. The borrower can owe more than the original amount, and in a falling market the balance can pass the value of the property.
Adjustable-Rate Vocabulary, Defined
The same handful of words carries every adjustable-rate item. Use this as the last pass before you sit, when you want definitions rather than explanation.
Index
The published market benchmark the adjustment formula is tied to. It belongs to the market, not to the lender, and it supplies the only figure in the calculation that changes over time.
Margin
The lender's fixed add-on, stated in percentage points in the note and unchanged for the term. Index plus margin gives the fully indexed rate at any adjustment date.
Teaser Rate
An opening rate set below index plus margin to hold early payments down. Because the formula rate is already higher, the first adjustment raises the rate even if the index has held perfectly still.
Adjustment Caps
Also called periodic caps: the limit on how far the rate may move at any one adjustment. They govern the size of a single step and say nothing about how far the rate can travel across the whole loan.
Lifetime Cap
The absolute ceiling for the loan, expressed as points above the rate the borrower started with. Measure it from the original rate, never from whatever rate is in force today.
Negative Amortization
A balance that grows because the capped payment no longer covers the interest accruing, so the shortfall is added to principal. It arises from a limit on the payment rather than a limit on the rate.
Frequently Missed Points on This Topic
What do the two numbers in an adjustable loan's name mean?
The first is the length in years of the opening fixed period. The second is how often the rate is recalculated after that period ends, also in years. So a loan labeled with a seven and then a one holds its rate for seven years and then adjusts once a year for the remaining term.
Which part of the rate does the lender control?
The margin, and only at origination. It is negotiated into the note and then fixed. The index is a published market rate that the lender neither sets nor can influence, which is precisely why it is used as the reference.
Can an adjustable rate ever go down?
Yes. If the fully indexed rate falls below the current rate at an adjustment date, the rate steps down, bounded by the periodic cap and by any floor the note specifies. Candidates who assume these loans only move upward miss items built on a falling index.
Why does a rate rise at the first adjustment when the index has not moved?
Because the opening rate was set below index plus margin as an inducement. The first recalculation replaces that discounted figure with the formula, so the rate rises on the arithmetic alone. This is the standard setup for a payment shock question.
Is a payment cap protection for the borrower?
It protects the size of the monthly payment, not the size of the debt. If the rate rises past what the capped payment covers, the unpaid interest joins the principal balance. A borrower looking for genuine protection wants limits on the rate itself.
How is a fixed-rate loan's payment split over time?
The payment amount holds steady while its composition shifts. Early payments are mostly interest because interest is charged against a large outstanding balance; as the balance falls, more of each identical payment retires principal. The total is level, the split is not.