When you apply for a home loan, one option to consider is an adjustable-rate mortgage, or ARM. An ARM loan has a lower fixed interest rate for the first years of repayment, then the ARM resets and the interest rate can go up or down throughout the remainder of the loan term.
While ARMs can make sense if you don’t plan to stay in a home long, ARMs do become unpredictable. Because the interest rate adjusts, the monthly payment fluctuates and can increase significantly, especially if interest rates go up. Having a clear understanding of adjustable-rate mortgage pros and cons as well as the various types of ARM loans can help you decide whether this loan type may be a good fit for you.
What is an adjustable-rate mortgage?
If you’re mortgage shopping and considering various loan options, you may wonder what is an ARM loan, and is it right for you? ARM stands for adjustable-rate mortgage. The adjustable-mortgage rate definition is a loan in which the interest rate and mortgage payment adjust up or down throughout the loan, depending on the overall economy.
While ARMs can be unpredictable, they typically have lower interest rates at the beginning of the loan when compared to fixed-rate mortgages. However, because the interest rate and monthly payments fluctuate throughout the loan, they can become much higher than the initial rate and payment.
What’s the difference between an adjustable-rate and fixed-rate mortgage?
Mortgages have either an adjustable rate or a fixed rate. As explained, adjustable rates fluctuate along with market conditions. On the other hand, fixed-rate loans do not change. The interest rate and monthly payment remain the same throughout the loan.
What is an ARM rate based on?
The interest rate on an adjustable-rate loan includes two components: an index and a margin. These two factors determine how high or low an ARM interest rate will go.
- Index: The index is a measure of interest rates that reflects the trends of the overall economy. Generally, the index will rise and fall according to market conditions. Different lenders use specific indexes; however, common indexes include the U.S. prime rate and the constant maturity Treasury (CMT) rate. Your lender will disclose which index they follow.
- Margin: The margin is the extra percentage that a lender adds to the index. Lenders will disclose their margin to you when you apply for a loan.
Index + Margin = ARM Interest Rate
As an example, if the index on a loan is 2% and the lender’s margin is 2.5%, then the initial ARM interest rate will be 4.5%.
How do adjustable-rate mortgages work?
If you’re considering an adjustable-rate mortgage, it’s essential to know how adjustable-rate mortgages work. Most adjustable-rate mortgages have an initial period followed by an adjustable period.
- Initial period. At the beginning of an adjustable-rate mortgage, the interest rate and monthly payment remain the same for a limited period. This period can last one month, several months, or several years, depending on the structure and type of adjustable-rate mortgage. (See more on the types of ARM loans below.)
- Adjustable period. After the initial period, the interest rate and payment will rise or fall according to the index. This is the adjustable period and lasts for the remaining life of the loan. During the adjustable period, the interest rate could adjust monthly, quarterly, annually, or every few years, depending on the loan terms.
What are the types of ARM loans?
There are multiple types of adjustable-rate mortgages, and their terms can vary greatly. Before deciding to get an ARM loan, familiarize yourself with the various options.
One of the most common types of ARM loans is a hybrid ARM. Because a hybrid adjustable-rate mortgage has a fixed-rate period and an adjustable-rate period, these loans can provide flexibility and some stability. Standard hybrid ARMs include 3/1, 5/1, 7/1, and 10/1 ARM mortgages.
- 3/1 ARM mortgage: The interest rate and payment remain fixed for three years and then adjust annually.
- 5/1 ARM mortgage: The interest rate and payment remain fixed for five years and then adjust annually.
- 7/1 ARM mortgage: The interest rate and payment remain fixed for seven years and then adjust annually.
- 10/1 ARM mortgage: The interest rate and payment remain fixed for 10 years and then adjust annually.
Other hybrid ARM structures exist. For example, a 5/6m ARM mortgage has a fixed interest rate and payment for the first five years and then adjusts every six months. Conversely, some hybrid ARMs adjust every three or five years.
It’s also common to see ARMs advertised as a 2/28 ARM or 3/27 ARM. In these instances, the first number refers to the fixed period: two years and three years, respectively. And the second number refers to the adjustable period: 28 years and 27 years, respectively. In both cases, the interest rate can adjust every six months, annually, or every few years, depending on the loan terms.
With an interest-only adjustable-rate mortgage, you’ll pay only the interest portion of the loan for a specified period. After the interest-only period, the monthly payment will increase even if the interest rate doesn’t because you’ll be paying both the principal and interest.
Some lenders offer payment-option adjustable-rate mortgages. With this type of ARM, borrowers can choose one of the following payment options:
- A principal and interest payment
- An interest-only payment
- A minimum payment (this option can result in negative amortization)
What is an ARM mortgage? Basic features explained
While the specific terms of ARMs will differ, you can expect adjustable-rate mortgages to have the following basic features:
- Initial interest rate and payment: This is the rate and monthly payment you’ll pay at the beginning of the loan.
- Initial or fixed period: This is the amount of time the initial rate and payment remain the same.
- Adjustable period: This is the portion of the loan during which the rate changes.
- Adjustment period: This is how frequently the rate will change during the adjustable period.
- Index: This is the benchmark interest rate the ARM rate is tied to.
- Margin: This is the number of percentage points a lender adds to the index.
- Fully indexed rate: This is the index plus the margin.
- Initial adjustment cap: This limits how much the interest rate can increase or decrease the first time it adjusts. Initial adjustment caps are typically either 2% or 5%.
- Subsequent adjustment cap: This limits how much the interest rate can increase or decrease in the adjustment periods after the first change. A typical subsequent adjustment cap is 2%.
- Lifetime adjustment cap: This controls how high the interest rate can increase over the life of the loan. A standard lifetime adjustment cap is 5%; however, some loans may have a higher cap.
- Payment cap: This limits how much the monthly payment can increase each time the rate adjusts.
- Floor rate: This refers to the lowest the interest rate will go.
Adjustable-rate mortgage pros and cons
Now that you know the answers to what is an ARM mortgage and how adjustable-rate mortgages work, it’s crucial to familiarize yourself with the disadvantages and advantages of adjustable-rate mortgages. Understanding the potential risks involved will help you determine if an adjustable-rate mortgage is right for you.
Here are some adjustable-rate mortgage pros and cons:
|Pros of adjustable-rate mortgages||Cons of adjustable-rate mortgages|
|ARMs have lower initial interest rates compared to fixed-rate mortgages.||Interest rates and payments can increase significantly.|
|ARM loan interest rates typically remain fixed for a set amount of time.||Interest rates and payments fluctuate up and down after the fixed period and can be unpredictable.|
|Loan caps limit how high the interest rate and payments can adjust.||Borrowers cannot estimate the total cost of the loan.|
|Interest rates can adjust down.||Loans can be confusing and hard to understand.|
|ARMS provides flexibility with affordable monthly payments initially.||Loans can become unaffordable.|
Who should get an adjustable-rate mortgage loan?
While most consumers opt for a fixed-rate mortgage, about 10% to 15% of homebuyers choose an adjustable-rate mortgage. These loans can be the right choice for some homeowners. For example, you might consider getting an ARM loan if:
- You expect to own your home for a short amount of time.
- You expect an increase in income and will be able to support higher payments in the future.
- You want the flexibility of lower payments initially.
- You can handle the fluctuations and unpredictability of ARMs.
What to consider when taking out an ARM
Here are some factors to think about when considering an adjustable-rate mortgage:
- Loan terms. Make sure you understand the various types of ARM loans and the terms. Specifically, you’ll need to know:
- When the interest rate will adjust
- How often the interest rate will adjust
- The interest rate cap
- The payment cap
- Whether the payment will adjust with the rate
- When the interest rate will adjust
- Affordability. Make sure you crunch the numbers to see if your budget can support the highest potential payment of the ARM.
- Current market conditions. While no one can predict the direction of interest rates, existing market conditions will help you determine if an adjustable-rate mortgage is right for you. If rates are low and will likely remain low and steady, an ARM can work to your advantage. However, if rates are volatile, an adjustable-rate mortgage could be risky.
Adjustable-rate mortgage (ARM) FAQs
How much can the payments on my ARM loan go up? All adjustable-rate loans have an interest-rate cap as well as a payment cap that spells out the maximum payment and interest rate your loan will have. Your lender can tell you these maximums based on the current interest rate.
Do ARM rates ever go down? Yes, the interest rates on adjustable-rate mortgages can drop along with market conditions. Keep in mind, though, that some loans have a “floor rate.” This means the interest rate will not drop below a specific mark.
Do you pay the principal on an ARM loan? Typically, you’ll pay both the principal and interest on an adjustable-rate mortgage unless you have an interest-only ARM loan. An interest-only adjustable-rate mortgage is one in which you’ll make interest-only payments for a specific amount of time before payments change to principal and interest.
Can I refinance an ARM before the rate adjusts? Yes, you can refinance or pay off an adjustable-rate loan before the adjustable period begins. While some mortgages do have prepayment penalties, ARMs generally do not carry them, so you’ll be able to pay it off without paying a fee. However, keep in mind that the value of your home and market conditions will determine whether or not you can refinance and if refinancing makes sense for you. As a result, there’s no guarantee you’ll be able to refinance an adjustable-rate mortgage before the fixed period ends.
Can I convert an adjustable-rate mortgage to a fixed-rate mortgage? Some adjustable-rate loans may have a conversion option. This can provide an alternative to refinancing the loan, which typically involves closing costs. However, borrowers should consider whether converting the loan makes sense since the fixed rate may be higher than market rates. Additionally, some lenders may charge a conversion fee.
If you’re ready to find the right mortgage for you, talk to a local Finance of America Mortgage Advisor today to learn more about your options.