What Is an Adjustable-Rate Mortgage (ARM)?
An adjustable-rate mortgage (ARM) is a type of mortgage loan with an interest rate that can change throughout its life. The interest rate is tied to a particular index; as the index change, so does your interest rate.
ARM interest rates usually start lower than with a fixed-rate mortgage; thus, it a popular choice among first-time home buyers.
However, many buyers don’t realize that their low ARM rate may last a short period (a year or less) and be replaced with a higher rate that will continue to increase or decrease periodically depending on market conditions.
If you see an ad with a low introductory interest rate, you’re likely looking at an adjustable-rate mortgage.
The interest rate on an adjustable-rate mortgage is made of two rates, an index rate plus a margin rate.
An index is an economic indicator published by a neutral party. If the index increases or decreases, so does your mortgage rate. Your ARM mortgage will be tied to an index that can be the Federal Reserve’sinterest rate, the LIBOR rate, or a different index the lender prefers.
A margin is an extra percentage the lender adds on top of the index rate. This is the lender’s profit margin on loan after accounting for funding costs.
Banks borrow funds too. Some lenders use their own cost as an index; this transfers all interest rate risks from the lender to the borrower, which means borrowers will pay more or less depending on how the index changes.
How Do ARM Mortgage Loans Work?
Homebuyers looking to buy a home are usually most concerned about the amount of their monthly mortgage payment, but they don’t spend enough time understanding the terms of their mortgage and how their loan works.
It may be a good option for first-time homebuyers looking for a lower monthly payment. However, be aware that those payments may increase after the teaser rate ends.
The teaser rate in an ARM loan applies only for an introductory period before reverting to a higher rate, which will continue to increase or decrease; this means your future mortgage payments will also increase or decrease.
Consider this – you inquire with a lender about their best ARM loan; it’s a 4% fully indexed mortgage (2.5% index plus a 1.5% margin). Your lender may offer you a 3% teaser rate for the first year; after that, the rate returns to the 4% indexed rate.
And rates may continue to increase at the start of every adjustment period.
For example, if the adjustment period in an ARM loan is 3/6m, your payments for the first three years will remain the same, but after that, payments may change every six months.
An ARM loan can save you money because the initial interest rate is lower than fixed rates, but your rate can adjust higher, so know what you’re getting into.
The maximum your ARM rate can increase by will depend on the cap.
All adjustable-rate mortgages have built-in caps meant to protect buyers from getting interest rate increases that they cannot afford. Thus, when applying for an ARM loan, make sure you can afford a mortgage payment that includes the cap.
An adjustable-rate mortgage is a great option if:
- You are planning to stay in the home only for the introductory rate period.
- You’re a savvy homebuyer and can afford increases to your interest rates.
Don’t choose an ARM loan if:
- You prefer the predictability of your monthly payment.
- You have a tight budget.
Read More: 21 Types of Mortgage Loan for Home Buyers
How Often Do ARM Mortgage Rates Adjust?
An ARM loan’s interest rate can change as frequently as monthly, quarterly, annually, or as stated in the adjustment period clause. The introductory rate typically lasts for three to five years before it starts adjusting periodically.
For example, when you see a 5/6m ARM advertised, it means the following:
The first number is the fixed period when the introductory rate applies. So in this example, the introductory rate does not change for the first five years.
The second number is the adjustment period, and it tells you how often the interest rate changes after the introductory rate ends.
ARM loans are actually 30-year mortgages, which means it will take you 30 years to repay the loan fully. However, the term has two components, the fixed period and adjustable period.
There are other aspects of an adjustable-rate mortgage you should understand, including the following:
- The teaser rate
- How long the teaser rate will last
- The timing of each interest rate adjustment.
- How much can the rate change from one period to the next?
- Minimum and maximum mortgage payment using the minimum and maximum interest rates.
- Mortgage term
- Index the ARM loan will be tied to and where to find it.
- What type of advanced notice will you receive before an adjustment?
ARM Rate Caps
ARM rate caps restrict how much your interest rate can change. This protects you from seeing unusually high rate increases. Thus, your ARM loan will come with three built-in caps that will protect you from big rate swings.
The three types of ARM caps are:
Initial adjustment cap: This is the maximum interest rate adjustment, right after the introductory teaser rate expires.
Subsequent adjustments caps restrict the rate by which interest rates can change from one adjustment period to the next.
For example, your loan agreement might state your interest rate cannot increase by more than 1% every six months.
Lifetime caps limit the maximum (and the minimum) interest rate adjustments over the loan’s life.
For example, if your lifetime cap is 3% and the initial rate was 3.5%, you will never pay more than 6.5% regardless of whether the index increases by more.
For example, let say you have a cap structure of 2/1/5. A cap structure is a numerical representation of each rate cap on your ARM loan.
So, if you have a cap structure of 2/1/5, here is what it means:
- The first adjustment can increase by no more than 2%.
- Each subsequent periodic adjustment can increase by no more than 1%.
- Over the life of the loan, interest cannot increase by more than 5%.
Basic Features Of An Adjustable-Rate Mortgage
There are five key features in an adjustable-rate mortgage. These are:
01 Introductory (teaser) rate: This is the rate you pay at the beginning of the loan, and it may last anywhere between a few months to a few years.
02 Adjustment period: The adjustment period is the length of time during which the introductory rate cannot change.
03 Index rate + Margin rate: Know your index and margin rate, including the market indicator tied to the index rate.
04 Interest rate caps: All ARM mortgages have caps the interest rate can change by. Make sure you know those caps so that you can understand what you agree to.
05 Conversion option: The agreement should include an option to convert the ARM loan to a fixed-rate mortgage after a certain period ends.
You should be aware of the mortgage loan features to determine whether you’re making the right decision. Don’t buy into an ARM thinking your mortgage payment will never change – it will.
Thus, before signing on the dotted line, ask your mortgage broker to explain each of the key loan features.
I know it can get complicated understanding things like margins, indices, caps, minimum and maximum mortgage payments.
Unless you understand those terms and how they impact your mortgage, you won’t be able to compare whether an adjustable-rate mortgage is right for you. In that case, you should consider getting a fixed-rate mortgage instead of an ARM.
Pros And Cons Of Adjustable-Rate Mortgages
Now that you know what an adjustable-rate mortgage is and how it works, here are the key advantages and disadvantages of getting an ARM loan.
The best advantage of an ARM loan is that the initial interest rate is lower than for a fixed-mortgage which translates into a lower mortgage payment and paying the loan faster.
This can be a great option for first-time homebuyers looking to get their foot in the door with an affordable mortgage or those who plan to flip the home before the teaser rate expires.
As for the downsides, there are risks interest rates could increase, and if that happens, homebuyers who are on a tight budget could face financial hardship or, worse, be unable to afford the higher mortgage payments.
If an ARM rate is so low that it sounds too good to be true, it probably is. The teaser rate could last a short period of time before the fully indexed rate kicks in, making the loan more expensive than what originally seemed.
When you apply for a mortgage loan, find out the maximum monthly payment you can afford and leave yourself some budget flexibility to account for a potential interest rate increase in the future.
Because there is the uncertainty of fluctuations, buyers will need to plan for rate increases. If rates rise and you need to refinance, you might not qualify under the higher rate.
Also, ARMs are more complex than fixed-rate mortgages. What may initially look like a bargain might turn into an expensive endeavor.
If you’re not financially savvy or prefer the predictability of a fixed monthly payment, a fixed-rate mortgage might be a more suitable option.
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Type Of Adjustable-Rate Mortgages
Now that you know what an adjustable-rate mortgage is and how it works, here are the key advantages and disadvantages of getting an ARM loan.
The most common types of adjustable-rate mortgages are hybrid ARMs that you’d normally see labeled as 3/1, 5/1, 7/1, and 10/1.
Remember, the first number is the fixed period when the introductory rate applies, and the second number represents how often the rate will change after that.
So, in a 3/1 ARM loan, the fixed rate will last for three years, and after that, the rate will change every year. Here are the most common types of ARM loans:
01. 3/1 ARM is a loan where your interest rate is fixed for the first three years; after that, the rate changes every year until the loan is paid off.
02. 5/1 ARM is a loan where your interest rate is fixed for the first five years; after that, the rate changes every year until the loan is paid off.
03. 7/1 ARM is a loan where your interest rate is fixed for the first seven years; after that, the rate changes every year until the loan is paid off.
04. 10/1 ARM is a loan where your interest rate is fixed for the first ten years; after that, the rate changes every year until the loan is paid off.
If you want the predictability of a stable monthly mortgage payment, you’ll want to choose an ARM that keeps the fixed-rate unchanged for longer. Thus, a 3/1 ARM might not be a good idea unless you plan to sell the home after three years.
The longer the fixed term, the better, especially if you’re a first-time homebuyer.
Avoid getting into a 1/1 ARM or an interest-only ARM. If home prices decline and the mortgage goes underwater, you won’t have much recovery time before the next interest rate adjustment comes.
When choosing what type of ARM loan is right for you, focus on the following five points:
- Can your budget handle paying the mortgage using the ARM cap rate?
- Do you plan to stay in the home after the introductory rate period
- Is your income a consistent amount from month to month?
- Can you understand the terms of an ARM loan?
- Do the teaser rate savings outweigh the risks of a higher monthly mortgage payment after the teaser rate expires?
If your answer to any of the above five questions is no, you’re probably better off choosing a fixed-rate mortgage instead of an ARM loan.
There is no way to predict the future, but if you want to try your chances, an ARM loan might be right for you.
For example, an ARM loan might be a great choice if your income is stable or you expect your income to increase and you can handle the risk of a higher mortgage payment.
The key is to understand the loan you’re signing into so that you can determine what the best choice is for you.
Deciding Whether An ARM Loan Is Right For You
For you to consider going with an ARM loan, the ARM’s rate must be lower than the fixed-rate mortgage. The bigger the difference, the better, but you’ll have to weigh in the risks and rewards for each option.
So, if you’re a first-time homebuyer and want to take advantage of the lower mortgage payment during the teaser period, this might be a good choice.
However, keep in mind that the teaser rate is temporary, and you must be able to afford the higher mortgage payment once the teaser period ends.
Thus, ARM loans might be ideal for house flippers if you have a temporary job relocation or if you think interest rates will decline in the future.
ARM loans are good if market interest rates decline and bad if market interest rates increase.
Similarly, if you expect your future financial situation to improve, such as if you expect to receive a salary increase or a promotion, it means you might be able to afford the inherent risk of a higher future mortgage payment.
However, if you have a tight budget, you don’t want that mortgage payment to change very much, so an ARM loan might be too risky.
The same goes if you plan to stay in the home for many years. The longer you want to stay in the home, the higher the chances rate will change within that timeframe.
Deciding on what mortgage is right for you is not all about going with the lowest mortgage payment. It’s also about the better option in the long run, including the impact on your current and future financial situation and how that fits in with your risk appetite.
A 5/1 ARM can be an excellent choice if there is a chance that you’ll want to move to a better neighborhood or house in five years. In the meantime, you benefit from a lower interest rate than what a fixed-rate mortgage has to offer.
As a backup plan, make sure you can convert to a reasonably good fixed-rate on year six.
For a 3/1 ARM or lower teaser term, you’ll want to pay close attention to the caps. If the caps allow a higher mortgage rate than the current fixed rate, that may be too much risk unless you’re only staying in the home for a brief period.
The Bottom Line
Whether you choose an adjustable-rate mortgage or a fixed-rate mortgage, homeownership is a long-term commitment. Thus, consider the stability of your finances in comparison with the risk of a changing mortgage payment.
Don’t get an ARM loan so that you can qualify for a higher mortgage amount. When rates return to normal, your bank account won’t survive it.
That’s not to say you shouldn’t benefit from a discount (teaser rate)! Just don’t count on that teaser rate being there for you in the future.
If you go for an ARM loan, make sure you can afford the mortgage at the maximum interest rate so that if rates increase, you can afford it. In the meantime, you can enjoy the ride of a low-interest rate for as long as it lasts.
Lastly, if thinking about all these options sounds too stressful, or if you want the reliability of a mortgage payment that never changes, ditch the ARM option and go with the fixed-rate mortgage.
If you are thinking of buying a home, you should check out our Home Buyer’s Online Course. This course will walk you through the entire Homebuying process step-by-step, and you will learn simple strategies to buy the home you want for a price you can afford.
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