An adjustable-rate mortgage (ARM), also known as a “variable-rate mortgage,” is a type of mortgage that offers a low introductory interest rate. When that period ends, the rate turns into a floating rate for the remainder of the mortgage loan. A floating rate is one where your interest rate can increase or decrease when housing market conditions change.
How Does an ARM Work?
Unlike fixed-rate mortgages, where rates don’t change during the life of the loan, adjustable-rate mortgages are set so that interest rates fluctuate with the housing market.
After an introductory interest rate — typically lower than fixed-rate mortgages — your loan’s interests can change periodically. This initial interest rate typically lasts for three, five, seven, or ten years, depending on your choice.
Note that, due to the fluctuating nature of the market, drastic changes can happen to your rates, increasing or decreasing your interest payment from those originally set in your introductory rate. Therefore, there’s an inherent risk element with ARMs that don’t exist with fixed-rate mortgages.
What are adjustment periods?
All ARMs have an adjustable-rate period that determines how often your interest rate changes. Typically, borrowers choose the adjustment period, which can be set for every month or quarter, for three or five years. After the set period passes, your rates are adjusted to reflect the current status of the housing market.
ARMs are commonly named after their adjustment period. For example, a loan with an adjustment period of five years is known as a five-year ARM, and its interest rates change once every five years.
What are indexes and margins?
The interest rate of an ARM has two parts: an index and a margin. The index is a general measurement of current interest rates, while the margin is an extra amount that the lender adds to your total rate. Unlike the index, margin rates typically stay constant throughout the life of the loan.
The total amount you have to pay after every adjustment period depends on the index and the margin. Hence, if the index rate increases, your total payments typically increase as well.
The rate that results from the index and the margin is known as the “fully indexed rate.” Lenders can use different indexes to base their ARM rates, the most common being the rates on 1-year constant maturity Treasury (CMT) securities, the London Interbank Offered Rate (LIBOR), and the Cost of Funds Index (COFI).
What are adjustment interest-rate caps?
All ARMs have an interest-rate cap that limits how much your interests can increase per adjustment period. This means that if your interest rates exceed the cap amount, your interests will only increase up to the limit set by the payment caps. However, some ARMs take the residual interest from the past rate increase and move it to your next adjustment period; this is known as a “carryover.”
There are two types of interest-rate caps:
- Periodic adjustment cap - Limits how much your interest rate adjustments can increase in a given adjustment period. For example, if your periodic adjustment cap is 2% and interest rates rise to 3% in an adjustment period, you would only pay up to the 2% cap.
- Lifetime cap - Limits how much the interest rate adjustments can increase over the life of the loan. For example, if your ARM has a 7% rate and your loan has a 7% lifetime cap, it can never exceed 14% throughout its lifetime.
Types of ARMs
The most common loan type for adjustable-rate mortgages, hybrid ARMs, have an initial fixed interest rate that changes later to an adjustable rate. Hybrid ARMs can be set for 1, 5, 7, or even 10 years, the most common being the 5/1 ARM, which has a fixed rate for five years and afterward varies every 12 months.
This type of ARM doesn’t require you to pay on your loan’s principal at first. Instead, it asks you to pay the accrued interests you owe each month for a specific time. After this period lapses, your loan amount is set so that you must pay the principal and any remaining interests accrued. Since Interest-only ARMs include floating interest rates, they also increase or decrease as the market fluctuates.
This ARM loan lets you choose between different payment options for your monthly mortgage payments. These include paying your principal and interest, only paying your interests, and paying a minimum amount of your interests. The latter is called “limited payment,” and any amount you don’t pay that month is added to the loan principal, which can increase the interest you pay.
What Are the Benefits of an Adjustable-Rate Mortgage?
Lower initial interest rates
In most cases, adjustable-rate mortgages start with lower interest rates than fixed-rate mortgages. The reasoning is simple: since banks know that you risk higher rates in the future, they use lower mortgage interest rates as an incentive to join. These low rates stay predictable and stable throughout the initial loan term but ultimately increase or decrease when reaching the floating rate phase of your ARM.
Interest rates and payments can decrease
Just like your ARM’s rates can increase from changing market conditions, so can they decrease. If this happens, your monthly payments are also reduced, and they can continue doing so as long as the market drop lasts.
Additionally, your payments can decrease in the long run if you pay extra on the principal balance of your loan each month. This is because you are decreasing the overall amount of your loan, which results in lower interests.
Note that your rates can still increase from housing market fluctuations, but the chances are that the monthly costs will be lower overall.
Payments can be flexible
Unlike fixed-rate mortgages, ARMs can come with flexible options that can help you reduce or increase the payments you make each month. Although some hybrid or interest-only ARMs come with flexible payments, the best examples are payment-option arms, which allow you to pay higher or lower amounts on your loan’s principal and interests.
What are the Downsides of an Adjustable-Rate Mortgage?
Interest rates can go up after the one–ten-year cap
After the initial period of your ARM, the chances are that the changing nature of the housing market can increase your rates. If this happens, you’ll be paying more interest than you would with a fixed-rate loan. For example, if you have a five-year ARM and you have reached the five-year cap, you can end up paying more if the house market conditions have increased. Compared to a fifteen-year fixed-rate mortgage, which locks your rate during the life of the loan, an ARM can seem like a riskier plan, especially if you don’t have the funds to pay any increases in your rates.
Fluctuating rates can make budgeting difficult
Because ARM rates are so dependent on the percentage points of changing market conditions, it might not fare well if you rely on budgeting your monthly income. For example, if you already have your paycheck divided into monthly expenses and don’t have any wiggle room for changes, a monthly rate increase can hinder your payment plans.
Your loan can go underwater
If your ARM has flexible payment options, or if you sign for a payment-option ARM, you need to make sure that you’re paying enough interest on your principal. This is because if you only pay the minimum amount every month, there’s a high chance that that interest will accrue, causing what is known as “negative amortization.”
With negative amortization, even if you pay your loan, the total amount will still go up in a way that you’ll owe more than what your home loan costs. This will make you go “upside down” or “underwater” on your loan, which can force you to refinance your mortgage loan for more affordable terms.
Bottomline: Who is an ARM best for?
Since there is a higher risk involved with adjustable-rate loans than with fixed-rate ones, ARMs are best suited for homeowners who plan to stay in a home for a shorter amount of time or who plan to sell their home sooner than later.
Although there are still risks involved with an ARM, borrowers would take better advantage of the initial fixed period rate and only have to weigh rate increases for a shorter time. For example, if you’re a homebuyer who works in the military and relocates every five years or so, going with an ARM would be a better option than a fixed-rate mortgage. The reason is that you’d be paying a lower initial interest rate and would later have the money to pay for any rate increases.
In contrast, if you’re a first-time homebuyer who’s planning to keep your home for a longer period of time, or indefinitely, then a fixed-rate mortgage would be a better option for you since you wouldn’t have to worry about any rate increases for as long as you keep your home. This would also allow you to budget your income better, as there won’t be any surprises while paying your loan.