Adjustable Rate Mortgages (ARMs) Explained

Adjustable Rate Mortgages (ARMs)

With an adjustable rate mortgage, the interest rate and monthly payments varies according to a specific benchmark. The initial interest rate is usually fixed for a period of time after which it is reset periodically. The interest rate paid by the borrower will be based on the benchmark plus an additional spread, called an ARM margin. Adjustable rate mortgages are also known as a “variable-rate mortgage” or a “floating-rate mortgage”.

Adjustable Rate Mortgages, or ARMs, differ from fixed-rate mortgages in that the interest rate and monthly payment move up and down as market interest rates fluctuate.

Rates on ARMs start low. Rates charged during the initial periods are generally 1 to as much as 2.5% lower than those on comparable fixed-rate mortgages (at least initially). After all, lenders have to offer something to make it worth their while to assume the risk of higher rates in the future.

With an ARM the key benefit to the borrower is that the mortgage will typically carry an interest rate that is lower than the rate on a comparable fixed rate mortgage (at least initially). Sometimes the rate can be as much as 1.5 to 2.5% below that of a fixed rate mortgage.

When evaluating an adjustable rate mortgage there are several features that you should consider.

1. Initial rate.

Be careful if the initial rate seems very low as it could be a “teaser” rate with a short duration that will then be adjusted upward. At a minimum, ask what the rate would be adjusted to if the initial rate ended today. The initial fixed-rate period can be as short as a month or as long as 10 years.

One-year ARMs, which have their first adjustment after one year, used to be the most popular adjustable, and were the benchmark. This transition to what has become the new standard that being the 5/1 ARM, which has an initial fixed-rate period that lasts five years; the rate is adjusted annually thereafter. That type of mortgage, which mixes a lengthy fixed period with an even lengthier adjustable period, is known as a hybrid.

Other popular hybrid ARMs are the 3/1, the 7/1 and the 10/1.

These hybrid ARMs — sometimes referred to as 3/1, 5/1, 7/1 or 10/1 loans — have fixed rates for the first three, five, seven or 10 years, followed by rates that adjust annually thereafter.

2. Benchmark the ARM is pegged to.

ARM rates are usually tied to some “published” index that reflects the general interest rate market. After the fixed-rate honeymoon, an ARM’s rate fluctuates at the same rate as the index. The lender finds out what the index value is, adds a margin to that figure and recalculates the borrower’s new rate and payment. The process repeats each time an adjustment date rolls around.

Major Indexes Most ARM rates are tied to the performance of one of three major indexes:

1. Weekly constant maturity yield on one-year Treasury Bill
The yield debt  securities issued by the U.S. Treasury are paying,  as tracked by the Federal Reserve Board.

2. 11th District Cost of Funds Index  (COFI)
The interest financial institutions in the western U.S. are paying  on deposits they hold.

3. London Interbank Offered Rate (LIBOR)    
The rate most international banks are charging each other on large loans.

Ask the lender how this works and try to get an understanding of how the benchmark rate has changed recently.

3. The cap.

Borrowers have some protection from extreme changes because ARMs come with caps. These caps limit the amount by which ARM rates and payments can adjust.

Caps come in a couple of different forms. The most common are:

  • Periodic rate cap: Limits how much the rate can change at any one time. These are usually annual caps, or caps that prevent the rate from rising more than a certain number of percentage points in any given year.
  • Lifetime cap: Limits how much the interest rate can rise over the life of the loan.
  • Payment cap: Offered on some ARMs. It limits the amount the monthly payment can rise over the life of the loan in dollars, rather than how much the rate can change in percentage points.

Interest-only ARMs

Around the turn of the 21st century, lenders began to market interest-only mortgages to middle-class borrowers. Formerly the preserve of what lenders called “affluent clients,” interest-only mortgages are usually adjustables. The borrower is required to pay only the interest for a specified period, often 10 years. After that, it adjusts to the going interest rate, as tracked by a specified index. The loan then amortizes at an accelerated rate. During the interest-only period, the borrower can choose to pay some principal, if they wish. By providing flexibility in the size of monthly payments, interest-only mortgages often are a good match for people with fluctuating monthly incomes: salespeople who are paid on commission and newly practicing doctors and physicians, for example.

Variety of flavors

Some ARMs come with a conversion feature that allows borrowers to convert their loans to fixed-rate mortgages for a fee. Others allow borrowers to make interest-only payments for a portion of their loan terms to keep their payments low. But no matter the exact terms, most ARMs are more difficult to understand than fixed-rate loans.

To keep your financial options open, make sure to ask the mortgage lender if the ARM is convertible to a fixed-rate mortgage. Also, ask if the ARM is assumable, which means when you sell your home the buyer may qualify to assume your existing mortgage. That could be desirable if mortgage interest rates increase dramatically.

What type of buyer are ARMs good for?

Adjustable rate mortgages tend to be attractive because of their lower initial rate. Your risk is that your rate and monthly payment will rise in the future. If you are confident that you can handle an increased payment in the future, or if you think you will be moving in a relatively short time, the savings with an ARM can be substantial.

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