What Is An Adjustable-Rate Mortgage (ARM)?

Last updated Jan. 26, 2025 by Charles Zemub

An adjustable-rate mortgage (ARM) is a type of home loan characterized by an interest rate that can change periodically, usually in relation to an index. Unlike a fixed-rate mortgage where the interest rate remains constant for the life of the loan, the rate on an ARM will adjust at specified intervals. The primary appeal of an ARM is the potential for lower initial payments compared to those of a fixed-rate mortgage, but the borrower assumes the risk that interest rates may rise in the future.

How Adjustable-Rate Mortgages Work

ARMs are structured with an introductory period where the interest rate is fixed, after which it begins to adjust periodically based on a specific benchmark or index, such as the LIBOR, COFI, or MTA. Typically, an ARM might begin with a lower interest rate than a traditional fixed-rate mortgage, making initial monthly payments smaller. This setup can be particularly enticing for borrowers who plan to sell or refinance their property before the adjustment period begins.

For example, a 5/1 ARM offers a fixed interest rate for the first five years, after which the rate adjusts annually. Hence, at the end of the fifth year, the interest rate and monthly payments can increase or decrease, depending on the market conditions.

Initial Interest Rate and Payment Caps

Most ARMs include caps on how much the interest rate can increase at each adjustment, as well as over the life of the loan. These caps can help protect the borrower from significant spikes in their loan payments. Usually, there are three types of caps: an initial adjustment cap, a subsequent adjustment cap, and a lifetime cap. For instance, an ARM with a cap structure of 5/2/5 may increase by a maximum of 5% at the first adjustment, 2% per subsequent adjustment, and a total of 5% over the life of the loan.

Advantages of ARMs

1. Lower Initial Rates: ARMs typically offer lower initial interest rates than fixed-rate mortgages, which can translate to lower monthly payments during the introductory period.

2. Potential for Lower Overall Costs: If interest rates do not rise significantly after the initial period, the borrower may pay less over the life of the loan.

3. Benefit of Falling Rates: If market interest rates decline, the borrower’s rate and monthly payment may drop accordingly.

4. Flexibility: ARMs can be advantageous for homeowners who do not plan to stay in their home long-term, as the lower initial cost can result in savings during the period they hold the loan.

Disadvantages of ARMs

1. Payment Uncertainty: The possibility that monthly payments will increase significantly can create budget uncertainty for borrowers.

2. Complexity: ARMs can be complex products with varying terms and structures that may be difficult for borrowers to fully understand.

3. Interest Rate Risk: Borrowers bear the risk of rising interest rates, which can increase the monthly payments significantly after the fixed-rate period.

4. Possibility of “Payment Shock”: Upon reaching the adjustable period, borrowers may face a considerable increase in monthly payment amounts, known as payment shock.

Types of Adjustable-Rate Mortgages

There are several types of ARMs, each with distinct features. Some common types include:

• Hybrid ARMs: These have an initial fixed-rate period before switching to variable rates. They are usually represented in numbers, such as 3/1, 5/1, 7/1, or 10/1, where the first number represents the fixed-rate term in years.

• Interest-Only ARMs (IO ARMs): These allow the borrower to pay only the interest for a certain number of years, after which payments increase to include the principal balance.

• Payment-Option ARMs: These offer different payment choices each month, including options to make a fully amortizing payment, an interest-only payment, or a minimum payment. The minimum payment option can lead to negative amortization, where the loan balance increases due to unpaid interest being added to the principal.

How Interest Rates Are Determined for ARMs

The interest rate on an ARM is determined by the index it is tied to and the margin set by the lender. The index reflects general market conditions, while the margin is a fixed percentage point added to the index rate to determine your mortgage rate. Common indices include:

• London Interbank Offered Rate (LIBOR): Although being phased out, it has been a common benchmark for ARMs.

• Treasury Constant Maturity Index (TCM): Based on the yield of U.S. Treasury securities.

• Cost of Funds Index (COFI): Typically used for ARMs issued by savings and loans.

• Mortgage-Backed Securities Index (MBS): Derived from the yields on mortgage-backed securities.

Choosing the Right ARM

Choosing the right ARM requires careful consideration of your financial situation, risk tolerance, and future plans. Here are some factors to consider:

• Time Frame: Consider how long you anticipate staying in the home. If you plan to move within a few years, an ARM with a longer fixed-rate period may benefit you.

• Interest Rate Trends: Assess current and projected interest rate trends. If rates are likely to rise, a fixed-rate mortgage might be a safer choice.

• Budget and Stability: Evaluate your capacity to handle potential increases in monthly payments. If you need a stable, predictable payment, an ARM may not be suitable.

• Loan Terms: Scrutinize the loan terms, including adjustment intervals, rate caps, and potential penalties for early payoff or refinancing.

FAQs

Q: Who should consider an adjustable-rate mortgage?
A: Borrowers who expect to move or refinance before their rate adjusts, or who anticipate a drop in future interest rates, may benefit from an ARM.

Q: What happens when the fixed-rate period of an ARM ends?
A: Once the fixed-rate period concludes, the interest rate will adjust according to the terms of the loan. This adjustment occurs based on the chosen index and can result in increased or decreased monthly payments.

Q: How are ARMs regulated to protect borrowers?
A: Lenders are required to provide borrowers with loan estimates and closing disclosures detailing how their ARM will work, including potential adjustments and rate caps. Compliance with regulations ensures transparency and aids borrowers in understanding their mortgage terms.

Q: Are ARMs a good option for first-time homebuyers?
A: Depending on their financial circumstances and future plans, ARMs can be a beneficial option for first-time buyers who are comfortable with potential rate changes or planning to move before rate adjustments occur.

Q: Can I refinance an ARM to a fixed-rate mortgage?
A: Yes, many borrowers refinance their ARM to a fixed-rate mortgage to lock in a stable rate before their initial fixed period ends or if interest rates are projected to rise.