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What is an adjustable-rate mortgage?

As its name implies, the main feature of an adjustable-rate mortgage (ARM) is the interest rate adjusts during the loan term. Most ARMs start with a promotional rate, which may change multiple times a year or at specific adjustment periods. When the promotional rate expires the rate increases up to a ceiling or cap set by the lender. Because the interest rate fluctuates up or down, the borrower's monthly payment can increase or decrease based on the performance of the particular rate index that the loan follows.

 Although an adjustable-rate mortgage may sound risky, given that the initial rate can end up higher, there are situations in which they make sense.
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Read on to learn more about how an adjustable-rate mortgage works.

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How do adjustable-rate mortgages work?

Applying for an ARM is just like applying for any other mortgage loan. The complexity of adjustable-rate mortgages (ARMs) is in how the interest is calculated and the fact that the interest rate adjusts, which makes the loan payments somewhat unpredictable.
To calculate the interest, the mortgage lender chooses an index or benchmark that the loan rate will follow and as this benchmark fluctuates, the interest rate changes up or down. The lender adds a margin, in the form of a percentage, and together the index and margin determine the total interest rate. The margin will remain the same over the life of the loan, but the index rate will vary based on the market index.

Two important rate periods to know about are:

  • Fixed period. All ARMS start with a fixed-rate period, typically one year. For example, a 3/1 ARM has a fixed rate for three years, and for the remainder of the loan the interest rate will adjust once a year
  • Adjustment period. This is a set amount of time during which the interest rate can adjust or reset. In other words, the period between the rate changes is the adjustment period.
When you have an ARM, your monthly mortgage payments will change month-to-month after the adjustment period, so it’s important that you have a steady income and the ability to make a payment, should the rate adjust higher.

How are ARM rates determined?

Rates are determined by several factors, including a market index or benchmark the lender chooses.
The lender adds a “margin” to the benchmark index interest rate. The margin is percentage points that increase the overall rate. Together, the index + margin = fully indexed ARM rate. When shopping for an ARM, be sure to ask the lender what margin they add. You may find that this number varies among lenders.

Advantages of adjustable-rate mortgages

There are several advantages of ARMs, especially these days as the fixed rate has recently increased.
  1. Lower initial interest rate. This lower initial rate makes ARMs very attractive. This provides some time to do renovations or potentially earn higher income, so when the rate adjusts higher, you’ll be in a stronger financial position.
  2. Lower monthly payments. A low introductory rate means lower payments each month. Even when the rate adjusts higher you may end up with a lower rate than you may have had with a fixed-rate loan.
  3. Better for short-term homeowners. Starting with a low rate is beneficial if you don’t plan to keep the house for many years 

Disadvantages of adjustable-rate mortgages

There are also disadvantages to be aware of:
  1. Unpredictable and complex. ARMs are not for homeowners who enjoy predictability in their financial endeavors. Although ARMs come with a rate cap, they are more complex than fixed-rate mortgages and many homeowners are surprised when it comes time for the rate to reset higher.
  2. Prepayment penalty. Some ARMs come with a prepayment penalty that the lender will charge if you sell the home and pay off the mortgage or refinance the loan before a certain period.
  3. Payment increases. Because the rate is adjustable, you’ll need to be prepared for monthly payments to go up periodically.

Types of adjustable-rate mortgages

All mortgages include principal and interest in the monthly payment. Principal is the original amount of the loan, and the interest is the rate that the loan is to be paid back.
There are several types of adjustable-rate mortgages homebuyers should be familiar with:
Fully amortizing ARM. While these loans are adjustable, the monthly payment is calculated so that the entire mortgage balance is paid off at the end of a 30-year term.
Interest-only (I-O) ARM. These loans have an introductory fixed rate followed by an adjustable rate. Many borrowers opt for this type of ARM because of the low monthly interest-only payments. The disadvantage is that the principal amount of the loan isn’t paid down, which creates a large “balloon” payment at the end of the loan or when the property is sold or refinanced. In this case, the borrower should be prepared to pay a large amount at the end of the loan term.
Payment-option ARM. This ARM provides the borrower with payment options that include:
  • Paying an amount that covers both the principal and interest.
  • Paying an amount that covers the interest only.
  • Paying a minimum monthly amount that does not cover the interest. This option leads to a balloon because the unpaid interest is added to the unpaid principal balance.

Hybrid ARMs

These loans blend features of a fixed-rate loan with an ARM. Hybrid ARMs have a fixed period at the start of the loan with no rate adjustment combined with a remaining loan period during which the rate does adjust.

Here are some of the Hybrid ARMs you may see advertised:
  • 5/1 ARM. Has a fixed rate for five years and for the remainder of the loan the interest rate will adjust once a year.
  • 10/1 ARM. ARM has a fixed rate for 10 years, and for the remainder of the loan the interest rate will adjust once a year.
  • 5/6 ARM. Has a fixed rate for five years and adjusts every six years.
  • 7/6 ARM. Has a fixed rate for seven years and adjusts every six years.
  • 10/6 ARM. Has a fixed rate for 10 years and adjusts every six years.

Important terms to know

Here are some important terms you should understand before deciding to get an ARM:
  • Variable rate. This indicates that the loan interest is calculated based on a market index that fluctuates.
  • Indexes for adjustable-rate mortgages. There are many market indexes that an ARM can follow, but the most often used are: London Interbank Offered Rate (LIBOR), Secured Overnight Financing Rate (SOFR), Federal Cost of Funds Index (COFI), Constant maturity treasury (CMT), the Prime Rate (the interest rate that banks use to set interest rates for loans), and a U.S. Treasury Bill rate.
  • Adjustable-rate mortgage margin. This is the number of percentage points the mortgage lender adds to the index.
  • Adjustable Interest rate caps. Although ARM interest fluctuates, all ARMs come with a cap or maximum threshold.
  • Adjustable-rate mortgage cap structure. The interest rate cap structure is how the mortgage lender structures the different types of rate caps. All lenders must disclosure how their ARM loan caps are structured. The caps protect the borrower from large interest rate swings.
  • Initial adjustment cap. This cap limits the amount the interest rate can increase the first time it adjusts after expiration of the fixed-rate period.
  • Periodic (subsequent) cap. This cap limits how much the mortgage interest rate can increase during the adjustment periods.
  • Lifetime cap or ceiling. This is how much the interest rate can increase in total, over the life of the loan.
  • Annual cap. This restricts the amount the ARM’s interest rate can go up or down in a given year.

Adjustable-rate mortgage vs. fixed-rate mortgage: which is better?

One option is not necessarily better than the other. Both loan types have advantages and disadvantages. However, these are generally based on the borrower’s income, financial goals, and homeownership goals. This is one of the main reasons there are so many loan types to choose from; there are mortgage options for just about every home financing need.

Are adjustable-rate mortgages worth it?

Whether or not an adjustable-rate mortgage is worth it is entirely up to you based on your unique financial situation. It may be worth it if you foresee earning more money in the future, so you won’t have to worry about the interest rate increase. If you’ll be keeping the home for less than five years, then you could save money with an ARM. However, if you need predictable monthly payments and are on a fixed budget, then an ARM would not be the best choice.

Is it possible to convert an ARM to a fixed-rate mortgage?

If you have an ARM it is possible to convert it to a fixed-rate mortgage. However, before you do, be sure to review the terms of your current loan to see if there is a prepayment penalty.

Are there limits as to how high ARM rates can go?

Yes, which is why there are several types of caps on these loans.
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