An adjustable-rate mortgage, or ARM, features an introductory interest rate that lasts for a specific amount of time and then adjusts at pre-set intervals for the remaining term of the loan. When the interest rate adjusts, your monthly payment will change. The monthly payment amount is typically capped.
The initial interest rate on an ARM is generally lower than that for a comparable fixed-rate mortgage. The initial fixed-rate term may be as short as a single month or up to 10 years. In the past, one-year ARMs, in which the first adjustment occurred after one year, were the most popular.
Today, the most popular adjustable-rate mortgage is the 5/1 ARM, which has a fixed-rate period of five years with a rate that adjusts annually thereafter. This type of mortgage is called a hybrid mortgage, as it combines a long fixed-rate period with a longer adjustable period. Other popular hybrid ARMs include the 3/1, 7/1 and 10/1.
Advantages of an ARM
An ARM comes with many advantages:
- Interest rates and payments are lower early in the loan than comparable fixed-rate loans
- Borrowers may take advantage of falling interest rates without refinancing
- Borrowers who do not plan to stay in the home for a long time can save money
Disadvantages of an ARM
An adjustable rate mortgage is considered a riskier loan than a fixed-rate mortgage because the interest rate will most likely go up after the fixed-rate period ends, particularly now that interest rates are at historic lows. Rates and payments may rise dramatically over years, as a 6% ARM could transform into an 11% mortgage in just three years if rates skyrocket.
The first adjustment tends to be the worst, as many annual caps do not apply to the first change.
Adjustable rate mortgages are also more difficult to understand than a fixed-rate loan, as they come with a wide range of features and terms, many of which are not easy to understand. Lenders have a great deal of flexibility in determining adjustment indexes, caps and margins, among other terms, and it can be easy for an inexperienced borrower to get stuck with a costly mortgage.
What Happens When An ARM Adjusts
It is possible to figure out how much your ARM's rate will increase or decrease based on the index or margin it is tied to. Common index rates associated with ARMs include LIBOR (London Interbank Offered Rate), T-Bill (U.S. Treasury Bill) and CMT (Constant Maturity Treasury). A margin is a fixed rate that is added to the index rate to find out the fully indexed rate for your ARM. Margin rates are negotiable when you obtain the loan.
If your index rate is 3% and your margin is 2%, your fully indexed interest rate will be 5%.
You will have some protection against an extreme change in your interest rate and payments with a cap limit, which is the maximum amount by which your mortgage rate and payments may adjust.
- Periodic rate cap, which limits how much the rate can change at once. This is typically an annual cap, which prevents your rate from rising more than a certain percentage during the year.
- Lifetime cap, which limits how much your interest rate can rise over the life of your mortgage.
- Payment cap, which limits the amount your payment can rise over the life of your mortgage in dollars, rather than percentage points.
If you are considering an adjustable-rate mortgage, do not be afraid to ask plenty of questions and make sure you understand your options and the loan terms you will receive. ARMs can be an excellent option for many borrowers, but they are not suitable for everyone.