What Is an Adjustable-Rate Mortgage (ARM)?
A variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index that reflects the cost to the lender of borrowing in the credit markets.
An adjustable-rate mortgage differs from a fixed-rate mortgage in many ways. More importantly, with a fixed-rate mortgage, the interest rate remains the same for the life of the loan. With an ARM, the interest rate changes periodically, usually relative to an index, and payments can go up or down accordingly.
To compare two ARMs, or to compare an ARM to a fixed-rate mortgage, you need to know your loan rates, margins, discounts, rate and payment on caps, negative amortization, payment options, and recasting (recalculating).
You should consider the maximum amount that could increase your monthly payment. The most important thing is to know what could happen to your monthly mortgage payment in relation to your future ability to pay higher payments.
Lenders generally charge lower initial interest rates for ARM mortgages than for fixed-rate mortgages. At first, this makes the ARM easier on your pocket than a fixed-rate mortgage for the same loan amount. Also, your ARM could be less expensive over a long period than a fixed-rate mortgage, for example, if interest rates are stable or falling.
Against these advantages, you must weigh the risk that an increase in interest rates will lead to higher monthly payments in the future. It’s a trade-off that you get a lower initial rate with an ARM in exchange for taking on more long-term risk.
Here are some questions you need to consider:
- Is my income enough or is it likely to go up enough to cover higher mortgage payments if interest rates go up?
- Will I take on other large debts, such as a car loan or school tuition, in the near future?
- How long do I plan to own this home? (If you plan to sell soon, rising interest rates may not be the problem they pose if you plan to own the home for a long time.)
- Do I plan to make additional payments or pay the loan off early?
How does an adjustable-rate mortgage work?
An adjustable-rate mortgage, or ARM, is a home loan that begins with a low fixed interest teaser rate for three to 10 years, followed by periodic rate adjustments. ARMs are different from fixed-rate mortgages, which maintain the same interest rate for the life of the loan.
With an adjustable-rate mortgage, your payments can increase or decrease with changes in interest rates, based on the terms of your individual loan and a benchmark interest rate index chosen by your lender.
In some cases, choosing an ARM over a fixed-rate mortgage could be a sound financial decision, potentially saving you thousands of dollars. You should always ask your lender to explain the risks of ARMs and exactly how much the payments could increase.
Some people believe that fixed-rate mortgages are always the best option. But ARMs can be an option for homebuyers who know they’ll have the loan for only a few years, says Don Maxon, a certified financial planner in San Rafael, California.
ARMs can make sense for clients who know they will be moving in the near future or know that they will pay off the loan in a few years, perhaps due to expected retirement or inheritance or another receipt of funds.
Indexes vs. Margins
At the end of the initial fixed-rate period, ARM interest rates will become variable (adjustable) and will fluctuate based on some benchmark interest rate (the ARM index) plus a fixed amount of interest above that index rate (the ARM margin). The ARMS index is usually a benchmark rate, such as the prime rate, the short-term US Treasury rate, or the federal funds rate.
Although the index rate may change, the margin remains the same. For example, if the index is 5% and the margin is 2%, the interest rate on the mortgage is adjusted to 7%. However, if the index is only 2% the next time the interest rate is adjusted, the rate drops to 4%, based on the 2% margin on the loan.
Is an Adjustable-Rate Mortgage Right for You?
An ARM can be a smart financial option if you plan to keep the loan for a limited period of time and will be able to handle any rate increases in the meantime.
In many cases, ARMs come with rate caps that limit how much the rate can increase at any one time or in total. Periodic rate caps limit how much the interest rate can change from one year to the next, while lifetime rate caps set limits on how much the interest rate can increase over the life of the loan.
Note that some ARMs have payment limits that limit how much your monthly mortgage payment can increase, in dollar terms. That can lead to a problem called negative amortization if your monthly payments aren’t enough to cover the interest rate your lender is changing. The amount you owe can continue to increase with negative amortization, even if you make the required monthly payments.
Adjustable-Rate Mortgage (ARM) Terminology
ARMs are significantly more complicated than fixed-rate loans, so exploring the pros and cons requires understanding some basic terminology. Here are some concepts that borrowers should know before selecting an ARM:
- Adjustment Frequency: Refers to the amount of time between interest rate adjustments (for example, monthly, yearly, etc.).
- Adjustment indices: interest rate adjustments are linked to a benchmark index. Sometimes this is the interest rate on a type of asset, such as certificates of deposit or treasury bills. It could also be a specific index, such as the Secured Overnight Financing Rate (SOFR), the Cost of Funds Index, or the London Interbank Offer Rate (LIBOR).
- Margin: When you sign your loan, you agree to pay a rate that is a certain percentage higher than the adjustment ratio. For example, your adjustable rate might be the one-year treasury bill rate plus 2%. That extra 2% is called the margin.
- Caps: refers to the limit on the amount that the interest rate can increase in each adjustment period. Some ARMs also offer limits on the total monthly payment. These loans, also known as negative amortization loans, keep payments low; however, these payments may cover only a portion of the interest owed. Unpaid interest becomes part of the capital. After years of paying off the mortgage, the principal owed may be more than the amount you initially borrowed.
- Maximum limit: it is the highest that the adjustable interest rate is allowed to reach during the term of the loan.
Types of Adjustable-Rate Mortgage (ARMs)
1. Hybrid ARMs
Hybrid ARMs are often advertised as 3/1 or 5/1 ARMs, you may also see advertisements for 7/1 or 10/1 ARMs. These loans are a combination or hybrid of a fixed-rate period and an adjustable-rate period.
The interest rate is fixed for the first few years of these loans, for example, for 5 years on a 5/1 ARM. After that, the rate can be adjusted annually (1 in the example 5/1), until the loan is paid off. In the case of ARM 3/1 or 5/1:
- The first number tells you how long the fixed rate period will last and
- The second number tells you how often the rate will adjust after the initial period.
You can also see ads for 2/28 or 3/27 ARMs, the first number tells you how many years the fixed interest rate period will be and the second number tells you how many years the loan rates will be adjustable. Some 2/28 and 3/27 mortgages adjust every 6 months, not annually.
2. Interest-only (I-O) ARMs
An interest-only (I-O) ARM payment plan allows you to pay only the interest for a specified number of years, usually 3 to 10 years. This allows you to have smaller monthly payments over a period. After that, your monthly payment will go up even if the interest rates stay the same because you have to start paying back the principal and interest every month.
For some I-O loans, the interest rate also adjusts during the I-O period. For example, if you take out a 30-year mortgage with an I-O payment period of 5 years, you can only pay interest for 5 years and then you must pay both principal and interest for the next 25 years.
Because you begin repaying principal, your payments increase after year 5, even if the rate remains the same. Keep in mind that the longer the I-O period, the higher your monthly payments will be after the I-O period ends.
3. Payment-option ARMs
A payment-option ARM is an adjustable-rate mortgage that allows you to choose from several payment options each month. Options typically include the following:
- A traditional principal and interest payment, which reduces the amount owed on the mortgage. These payments are based on a set loan term, such as a 15, 30, or 40-year payment schedule.
- An interest-only payment, which pays interest but does not reduce the amount you owe on your mortgage while you make your payments.
- A minimum (or limited) payment that may be less than the amount of interest owed that month and cannot reduce the amount owed on your mortgage. If you choose this option, the amount of any unpaid interest will be added to the principal of the loan, increasing the amount you owe and your future monthly payments, and increasing the amount of interest you will pay over the life of the loan. loan. Also, if you pay only the minimum payment in the later years of the loan, you may owe a larger payment at the end of the loan term, called a balloon payment.
The interest rate on a payment-option ARM is usually very low for the first few months (2% for the first 1 to 3 months). After that, the interest rate generally goes up to a rate closer to that of other home loans.
Your payments for the first year are based on the low initial rate, which means that if you only make the minimum payment each month, it will not reduce the amount owed and may not cover the interest owed.
The pros of an adjustable-rate mortgage
1. Low payments in the fixed-rate phase
A hybrid ARM offers potential savings in the initial fixed-rate period. Common ARM terms are 3/1, 5/1, 7/1, and 10/1. With a 5/1 ARM, for example, your introductory interest rate is fixed for five years before it can change. That gives you five years of low, predictable payments.
An ARM may be a good idea if your life is likely to change in the next few years – for example, if you plan to move or sell the house. You can enjoy the fixed-rate ARM period and sell before the less predictable adjustable phase ends and begins.
3. Rate and payment caps
ARMs can have several types of limits, which limit increases in your mortgage rate and the amount of your payment. These include limits on how much the rate can change each time it is adjusted and the total rate changes over the life of the loan.
4. Your payments could decrease
If interest rates drop and lower the rate your ARM is compared to, there is a chance that your monthly payment will go down.
The cons of an adjustable-rate mortgage
1. Your payments could increase
If interest rates are increasing, your payments could increase after the adjustable period begins; some borrowers may have trouble making larger payments.
2. Things don’t go as planned
ARMs require borrowers to plan when the interest rate begins to change and monthly payments can increase. However, even with careful planning, you may not be able to sell or refinance whenever you want. If you can’t make your payments after the fixed-rate phase of the loan, you could lose your home.
3. Prepayment penalty
Some ARMs come with a prepayment penalty. This is a fee that can be charged if you sell or refinance the loan. If you plan to sell the home or refinance it within the first five years of the mortgage, you should choose a lender that offers a loan without this penalty.
4. ARMs are complex
ARMs can have complicated rules, fees, and structures. These complexities can pose risks for borrowers who do not fully understand what they are getting into.