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What Is An Adjustable Rate Mortgage (ARM)?

What is an ARM, and how does it work? Here, we’ll discuss the ins and outs of adjustable-rate mortgage options and see if an ARM is the right type of mortgage for you.

What Is An Adjustable Rate Mortgage?

An adjustable-rate mortgage (ARM) is a mortgage loan with an interest rate that changes over time. Compared to a fixed-rate mortgage that has a locked-in interest rate, an adjustable-rate mortgage comes with payments that will vary month-to-month as the interest rate changes.

Adjustable-rate mortgages typically come with lower initial interest rates than fixed-rate mortgages. Still, borrowers run the risk of having to pay higher payments if that interest rate ever rises. To find out if an adjustable-rate mortgage is a smart option for financing, let’s look at how it works and compares to other types of loans.

How Does An Adjustable Rate Mortgage Work?

To understand how an ARM works, we need to look at the different factors that impact the monthly payment and changing interest rates.

Initial Rate And Payment

If you opt for an ARM, you will get an initial rate and payment period for the first few months of your loan. This means that for up to five months, your payments will remain the same. After this time, however, they will go up or down depending on current market values.

Adjustment Period

Instead of changing every month, your ARM will come with a preset adjustment period, meaning that your rate can change either every month, quarter, year, three years, or five years.

The Index

Lenders will base your interest rate on an index that calculates market-wide interest rates. Your rate will rise and fall with the index over time. Indexes are records like the Cost of Funds Index or an index of the lender’s own funds. Ask your lender what index they use and where to find the records since most are published or made public.

The Margin

On top of the index rate, your lender will add a personal margin to your ARM that typically stays fixed over the life of the loan. Margins vary depending on the lender you choose. Some lenders assign lower margins to borrowers with good credit history if they deem the mortgage as lower-risk.

Interest Rate Caps

Fortunately, your ARM comes with caps that limit how much the interest rate can increase. The periodic adjustment cap limits how much the rate can change between each period, and the lifetime cap limits how much it can grow over the entire life of the loan.

Payment Caps

Along with interest rate caps, your ARM comes with a payment cap limiting the amount that your payment can increase between pay periods. This prevents your monthly payments from skyrocketing from one month to the next. Any interest that’s not paid off due to a payment cap (e.g., if the payment cap limits your monthly payment at $1300 when the payment plus interest is $1335), then the leftover interest to be paid is added to your overall loan amount.

Types Of Adjustable Rate Mortgages

There are several types of adjustable-rate mortgages. Some ARMs will appear with different rates represented as fractions (e.g., “5/1”), while others give flexible payment options.

Hybrid ARMs

Hybrid ARMs are a mix of fixed-rate and adjustable-rate features. You’ll see them as 5/1 or 3/1 ARMs. The first number of the fraction tells you how long the interest rate will be fixed, and the second number tells you how often that rate will adjust after the initial fixed period.

Interest-Only ARMs

Interest-only (I-O) ARMs allow you to only pay off interest for a set amount of time at the beginning of the loan. This means that your initial payments will be smaller and will increase after the initial period to cover the principal balance along with interest.

Payment-Option ARMs

  • Payment-option ARMs give you several different ways to make monthly payments.
    With a traditional payment plan, you begin to pay off both the interest and principal balance at the beginning of your loan.
  • An interest-only payment allows you to make lower initial payments that pay off the interest and not the principal.
  • Minimum payments or limited payments are an option to make ever smaller payments that don’t meet monthly interest rates. Any leftover interest that you do not pay is added to your mortgage, but you aren’t penalized for making the low payment.

What Should You Consider When Choosing An ARM?

Choosing to take out an adjustable-rate mortgage depends largely on your financial situation and what kind of payments you will be able to make each month.

How Long Are You Planning On Living In This Home?

One great perk of an ARM is that it front-loads the mortgage with lower payments. If you have a 5/1 ARM, for example, you’ll be paying a lower mortgage for five years. If you’re not planning on staying in your home for more than a few years before selling, this is a great option to decrease your mortgage payments.

Is Your Income Stable?

Since you’ll have to pay monthly payments towards your mortgage, it’s important to make sure that you have enough income to accommodate ARM payments along with the rest of your living expenses.

How Much Time Do You Need To Afford A Larger Payment?

I-O and limited payment options give you the chance to get your ducks in a row before making larger payments but still require strategic planning. How much time will it take to afford larger payments, and how will the rest of your expenses work around your ARM?

Are You Expecting Big Life Changes In Short Term?

Since your payments will most likely increase after your initial term, it’s essential to keep in mind big changes in your future that might affect your finances. If you’re getting a pay raise, you might be able to easily accommodate those higher payments. On the other hand, if you’re about to buy a car, bigger payments might prove difficult.

What ARM Options Does Your Lender Offer?

Individual lenders offer specific ARM options. If your lender doesn’t provide an ARM type that works with your finances, you’ll have to either find another lender or consider one of their other options.

ARM: Pros And Cons

What are the advantages of an adjustable-rate mortgage? While ARMs have some great benefits, they also come with some added risk from fluctuating interest rates.

What Are The Benefits Of Adjustable-Rate Mortgages?

  • Low Payments: As we discussed, ARMs have options for low payments that extend the lifetime of your loan but give you freedom with your monthly income.
  • Flexibility: With various payment options and caps, you can create a payment plan with your lender that works for your specific needs.
  • Payments Could Decrease: Although you should expect your interest rate to rise after the initial period, market interest rates can decrease over time. This is a possibility that won’t benefit a fixed-rate mortgage.
  • Payment and Rate Caps: The caps placed on the interest rate and payment amount provide some protection from market fluctuations and ensure that although your payments might increase incrementally, you’ll never be hit with skyrocketing payments that you can’t afford.

What Are The Disadvantages Of Adjustable-Rate Mortgages?

  • Prepayment Penalties: Most I-O and limited payment ARMs come with prepayment penalties, which are fees that you have to pay if you choose to pay off your loan before the term or if you want to refinance out of the loan. These penalties can cost up to thousands of dollars.
  • Flexibility: Unlike a fixed-rate loan, which tells you upfront what your final mortgage will cost, an ARM is subject to market changes and fluctuations over the term of your loan. This means that you don’t know exactly how much your mortgage interest rates will cost.
  • ARM Complexity: Adjustable-rate mortgages are complicated and have many changing factors that affect your payment. It’s important to ask your lender for all fees and possible scenarios when looking at ARM options to make sure you understand your payment options.

Which Is Better: Fixed Or Adjustable-Rate Mortgages?

If you currently can’t afford fixed-rate payments but feel confident that you can make higher payments after an initial period of time, an ARM might be a good option for you. However, if you feel more comfortable knowing what the entire cost of your mortgage will be and can make payments to both interest and principal, you might want to consider the fixed-rate mortgage.

An adjustable-rate mortgage can be a bad decision if there’s any possibility that you won’t be able to make those higher monthly payments after the initial period. Make sure that you’re aware of any possible changes in your income or financial plan before you choose an ARM.

When You Should Consider an Adjustable-Rate Mortgage

An adjustable-rate mortgage allows borrowers to benefit from potential drops in interest rates and to make smaller payments for the first few years of their mortgage. If you’re prepared for changing monthly payments, it’s a great, flexible alternative to a fixed-rate loan and can enable you to buy a house while maintaining some fluidity in monthly income and preparing for your financial future.

 

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This page last updated: March 21, 2022