What is an Adjustable Rate Mortgage?

Mar 20, 2023

7

min read

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inancing a home can be a daunting task since there are plenty of mortgage options to choose from. However, most people default on getting a fixed-rate mortgage for long-term stability and security. But here's the thing: fixed rates are inflexible, and you can miss out on lower interest rates.

But what if you can take advantage of lower interest rates while maintaining stability? That's where adjustable-rate mortgages (ARMs) come in.

So, what are adjustable-rate mortgages (ARMs), and how do they work? This article covers everything you need to know about adjustable-rate mortgages. So, let’s dig in!

What Is an Adjustable-Rate Mortgage?

An adjustable-rate mortgage is a type of mortgage in which interest rates change or adjust over time. The rates are determined by a financial index such as London Interbank Offered Rate (LIBOR) or the Treasury Constant Maturity (TMT) rate. In addition to the index rate, the lenders add a margin to determine the adjusted interest rate.

The initial interest rate and monthly ARM loan payments are usually less than the fixed-rate mortgage. But, these rates are subject to change and may go up or down based on the financial index.

Terms Related to Adjustable Rate Mortgage

Adjustable rate mortgages are quite complex compared to other mortgages. Here are some key terms you need to understand about ARMs.

Initial interest rate: This is the interest rate that applies during the initial fixed period of the ARM. It's also called a "teaser rate" or "introductory rate" and is often lower than the initial rate for a fixed-rate mortgage.

Initial fixed period: The interest rate for an ARM is fixed for a certain period, known as the initial fixed period. This can range from 3 to 5 years.

Adjustment period: After the initial fixed period, the interest rate on an ARM can change periodically. The adjustment period refers to how often the rate can vary annually or every six months.

Financial index: The interest rate for an ARM is based on a benchmark interest rate known as the financial index. Usually, the index used for ARMs includes the London Interbank Offered Rate (LIBOR), the Cost of Funds Index (COFI), and the Constant Maturity Treasury (CMT) index.

Margin: The lender's profit margin on the ARM is expressed as a percentage known as the margin. The margin is added to the financial index to determine the fully indexed interest rate.

Rate cap: It determines a limit on how much the interest rate can increase or decrease at each adjustment period and over the life of the loan. Generally, there is a periodic cap that limits changes at each adjustment period and a lifetime cap that limits changes over the life of the loan.

Payment cap: A payment cap limits how much the monthly payment can increase or decrease at each adjustment period. This protects borrowers from large payment shocks if interest rates rise rapidly.

How Does Adjustable Rate Mortgage (ARM) Work?

Let's consider an example to help you understand how an Adjustable Rate Mortgage (ARM) works.

Suppose you take out an ARM with a 5% initial rate for a 5-year fixed period, after which the rate will be adjusted annually. After 5 years, the interest rate will be adjusted based on the financial index rate.

So, let's say the index rate increased by 1%. So, your initial rate is now 4%. The lender added a 2% margin on the rate. So your adjusted rate will be 6%. This new rate will be fixed for next year and readjusted annually.

Now, you might be worried about the possibility of the continuous rise of interest rates. But, ARMs come with caps that limit how much your interest rate can increase or decrease each year and over the life of the loan.

So, let's suppose your ARM has a 2/2/5 cap. This means your rate can increase to 2% after the first adjustment and up to 2% yearly. Additionally, the rate cannot exceed 5% more than the initial rate for the life of the loan.

Since the initial interest rate is 5% and the cap is 5%, you can rest assured that your interest rate won't exceed 10% (5% + 5%) for the life of your loan. These caps protect you from large payment increases in a single year or over the life of the loan. As a result, you can gain some stability and predictability in the borrowing process.

Is ARM the Right Choice for You?

Well, it depends. But here are some pros and cons of ARM to help you decide if it is the right choice for your situation:

Pros of ARM

Lower Initial Interest Rate

Generally, ARMs offer lower initial interest rates compared to fixed-rate mortgages. This makes them more affordable in the short term, as less interest means you can put more money toward your principal balance. Eventually, you can pay back the loan faster.

Potential for Lower Monthly Payments

If the interest rate decreases after a fixed period, you can enjoy the low-interest rate and monthly payments. Unlike fixed-rate mortgages, you don't have to get into a hassle to refinance your loan when the interest is low, as it is adjusted automatically.

Best for Short-Term Investment

An ARM can be the best for you if you are considering financing a starter home or flipping homes. This allows you to pay lower monthly payments till you sell the homes.

Capped Interest Rate

You don't have to worry about rising interest rates since the rates are capped to a limit. It can't increase beyond the cap limit giving you stability.

Cons of ARM

Risk of Higher Interest Rates

On the downside, if interest rates, the interest rate on an ARM can increase significantly. So, this can lead to higher monthly payments, which can financially strain you.

Complexity

ARMs are more complex than fixed-rate mortgages, with different structures, terms, and conditions that might be hard to understand. You must clearly understand the technical terms related to mortgages, such as caps, index, margin, mortgage contracts, etc.

Confused about finances — Source: Freepik

Uncertainty

The ARM rates are tied to the financial index, which fluctuates over time. So, there is uncertainty about the interest and monthly payments. This can be difficult to come up with a financial plan and budget.

Limits on Low Rates

The ARM also has limits and caps on low rates. So, even if interest rates are low, the caps in the mortgage prevent you from enjoying the full benefit of low rates.

Different Types of ARM Loans

When selecting an adjustable-rate mortgage (ARM), there's no one-size-fits-all solution. You'll want to consider various ARM options depending on your financial situation and long-term goals. Here are some of the most common ARMs

Hybrid ARMs

Hybrid ARMs are the most common ARMs and a combination of fixed mortgages and ARMS. In this mortgage, you have initial fixed interest for a certain period, usually 3, 5, 7, or 10 years. After the fixed period ends, the interest rate adjusts annually based on the index rate and margin.

The most common hybrid ARMs are 5/1 and 5/6 ARMs. For 5/1, the rate adjusts once a year; with 5/6 ARM, the rate adjusts every 6 months. Other popular ARM options are 7/1 and 7/6 ARMs and 10/1 and 10/6 ARMs.

Interest-only ARMs

As the name suggests, Interest only ARMs require you to pay the interest on a specific period, generally 5, 7, or 10 years. After that, you must start paying both the principal and interest, and the interest rate will adjust annually based on the index rate and margin.

Payment-option ARMs

Payment-option ARMs, also known as pick-a-payment loans, allow you to choose from several monthly payment options, such as minimum payment, an interest-only payment, or a fully amortizing payment. These ARMs are complex and riskier since you might owe much more than the original mortgage. Thus, these ARMs have been rare after the 2008 great recession.

ARM Mortgages VS Fixed-rate Mortgage

Here are some key differences between adjustable-rate mortgages (ARMs) and fixed-rate mortgages:

	Adjustable Rate Mortgage	Fixed Rate Mortgage
Interest rate	Can change periodically based on a financial index plus a margin set by the lender	Fixed for the life of the loan
Initial fixed period	Typically 3, 5, 7, or 10 years	Entire life of the loan
Initial interest rate	Lower than fixed rate mortgage	Higher than ARM and fixed for the life of the loan.
Monthly payment	May vary over time.	Fixed throughout the life of the loan
Flexibility	Flexible than fixed mortgage	No flexibility since it is fixed at the time of contract.
Interest rate predictability	Low during adjustable period	High as the rate is fixed.
Interest risk	High since there is high uncertainty	Low since the market rate doesn't impact the loan rate.
Complexity	ARMs are hybrid mortgages, so understanding them is a bit complex.	Simple to understand

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Overall, ARMs offer lower initial interest rates and more flexibility than fixed-rate mortgages but come with the risk of interest rate increases and payment variability.

On the other hand, Fixed-rate mortgages offer higher interest rate predictability and payment stability but may be less flexible and may not allow you to take advantage of lower interest rates in the future without refinancing.

Best ARM Lenders

Choosing right lender is as important as choosing the right loan. There are plethora of lenders available in market and you might be confused which lenders to choose. To help you with the decision, here are our top picks that you can choose from:

Bank of America

Bank of America offers 5/6m, 7/6m, and 10/6m ARMs. They specialize in low down payment options and provide various online tools to help borrowers compare and select the right loan for your needs.

Chase Bank

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Chase Bank offers a variety of ARM loans, including 5/6m, 7/6m, and 10/6m ARMs. They specialize in refinancing existing mortgages and provide various options to help you lower your monthly payments or repay your loans faster.

Quicken Loans

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Quicken Loans offers 5/1, 7/1, and 10/1 ARMs and interest-only ARMs. They specialize in online lending and provide various tools to help you compare rates, estimate your monthly payments, and complete your applications online.

U.S. Bank

U.S. Bank offers 5/1, 7/1, and 10/1 ARMs. They specialize in fixed-rate to ARM conversions and provide various options to help you switch to an ARM loan and save money on your monthly payments.

Flagstar Bank

Flagstar Bank offers a variety of ARM loans, including 5/6, 7/6, and 10/6 ARMs. They specialize in adjustable-rate jumbo loans and provide various options to help you finance higher-priced homes.

Amerisave

Amerisave offers 5/1, 7/1, and 10/1 ARMs, interest-only ARMs. They also specialize in online lending, which makes the application process easy and convenient. Also, it is known for its affordable rates and top-notch customer service.

Guaranteed Rate Mortgage

Guaranteed rate mortgage offers 5/1, 7/1, and 10/1 ARMs. They are best known for providing knowledgeable and experienced loan officers that guide you throughout the process and help you find a personalized loan that works for you.

New American Funding

New American Funding offers a variety of ARM loan options, such as adjustable-rate mortgages, such as 5/1 and 5/6 ARM as well as conventional, FHA, and VA ARM. They are known for their flexible underwriting process and ability to work with borrowers with nontraditional credit histories.

Alliant Credit Union

Alliant Credit Union offers a variety of ARM loan options such as 3, 5, 7, or 10-year. They offer competitive rates, online applications, and an expert team that helps you get personalized loan that fits your budget and needs.

PNC Bank

‍PNC Bank offers a variety of mortgage products, including 7 and 10 years adjustable-rate mortgages. They have a user-friendly online application process and offer competitive rates. Additionally, PNC Bank is a well-established national bank with a long history in the mortgage industry, so you can feel confident in their expertise and experience.

Conclusion

With an ARM, you can lock in a low-interest rate for an initial period and enjoy the market-adjusted rates afterward. It's like having the best of both worlds – stability and flexibility. But, it comes with a risk such as high-interest rates and payment shocks. So, if you are a risk taker looking for short-term financing, ARM can be an excellent choice.