Adjustable Rate Mortgage (ARM) Topics Covered
- What is an Adjustable Rate Mortgage?
- Who is an Adjustable Rate Mortgage good for?
- Adjustable Rate Mortgages vs. Fixed Rate Mortgages
- Important Considerations with an Adjustable Rate Mortgage
- Adjustable Rate Mortgage FAQs
If you’re planning on getting a mortgage, there are a few different types to consider. Each one has its advantages and drawbacks, so determining which one will work best in your situation is important. One kind of mortgage to consider is an adjustable rate mortgage (ARM).
You may also hear ARMs referred to as variable-rate mortgages or floating mortgages.
What is an Adjustable Rate Mortgage?
Basically, an ARM is a home loan with an interest rate that adjusts over time based on market conditions. Its initial rate stays the same for a fixed period of time; at the end of the fixed period, the interest rate is changed in accordance with the value of a specified economic indicator, also known as an index.
While there are many indexes used to govern ARMs, the most prevalent types are:
- Treasury Constant Maturities (most common index; used on one-year ARMs and hybrid ARMs)
- Treasury Bills (mostly used for three month and six month ARMs)
- 11th District Cost- of-Funds (used mainly on one month and six month ARMs)
To protect you from large rate increases, most ARMs feature some form of limitations on how much your rate can move from fixed period to fixed period. These limitations are called caps. Although many kinds of cap structures are possible, the most common kinds of caps limit your change at any one time to two percentage points, and a total of six percentage points over the life of the loan. In many cases, these caps also restrict how low your rate can go.
Traditional ARMs have interest rates and monthly payments that adjust at fixed, regular intervals.
Hybrid ARMs feature a fixed interest rate for a period of years — commonly 3, 5, 7 or 10 years — before they turn into a traditional one-year ARM for the remainder of a 30-year term.
Numerical form is also used to represent different types of ARMs. This structure involves two numbers: the first number is how long your fixed-rate period will last and the second number is how often the rate will change every year.
The most common types of ARMS are 5/1, 7/1, and 10/1.
- A 5/1 ARM has a fixed rate of interest for the first 5 years of the loan. After that, the interest rate will adjust once annually over the remaining 25 years.
- A 7/1 ARM has a fixed rate of interest for the first 7 years of the loan. After that, the interest rate will adjust once annually over the remaining 23 years.
- A 10/1 ARM has a fixed rate of interest for the first 10 years of the loan. After that, the interest rate will adjust once annually over the remaining 20 years.
Who is an Adjustable Rate Mortgage good for?
An ARM can be a smart financial choice for home buyers that are planning to pay off the loan in full within a specific amount of time. If you plan to move or sell your house within a few years, you can reap the benefits of a low fixed rate and sell the home before it adjusts.
If mortgage interest rates fall, you could get an even lower monthly payment than you had before. Also, if rates do fall, you’ll be able to reap the benefits without having to go through the costs or paperwork of a refinance.
Adjustable Rate Mortgages vs. Fixed Rate Mortgages
There are several key differences between ARMs and standard fixed-rate mortgages.
- Fixed-rate loans are most commonly offered as 15- or 30-year terms or custom-term loans, but ARMs are typically 30-year terms.
- Your starting rate may be lower for an ARM than a fixed-rate mortgage.
- The monthly mortgage payment may be more affordable in the first few years of an ARM.
- The minimum down payment for an ARM is 5%, while the minimum down payment for a fixed-rate mortgage can be as low as 3%, depending on the loan
Important Considerations with an Adjustable Rate Mortgage
- What’s the current interest rate environment? It can make more sense to get an ARM when interest rates are on the rise, as long as you plan on moving before your rate adjusts.
- How long are you planning on living in your home? An adjustable rate mortgage is an excellent option for those buying a starter home who plan on moving into a bigger house within the next 5 years.Typically, committing to a 30-year fixed-rate mortgage won’t grant you the same flexibility as an adjustable rate mortgage. If interest rates continue to rise as predicted through the new year, then an ARM could make more financial sense than a fixed-rate mortgage for your home loan.
- Do you expect any big life events in the next 5 – 10 years (marriage, children, new job)?
- Do you need time to comfortably afford a bigger monthly payment?
- Is your income unstable or going to be unpredictable in the next few years?
- What adjustable rate mortgage options does your lender offer? Remember, different types of ARMs work better in different circumstances. If you plan on living in your home for less than 10 years, a 5/1 or 7/1 ARM may be a good option for you. But if you plan on living in the home long-term or need extra time to create a firm financial footing, a 10/1 may be a better choice.
Frequently Asked Questions
How often does an adjustable rate mortgage change?
ARM mortgage rates will adjust based on a few factors that are determined when the loan is established. These are: the adjustment period (how frequently the lender can adjust the interest rate on the loan), the periodic cap (the time period between each time the loan will adjust), and the lifetime cap (how much the loan can increase over the life of the loans).
What is a margin?
A margin is the number of percentage points the lender adds to the index rate to calculate the interest rate of an ARM at each adjustment. The margin of an ARM is set in your loan agreement and won’t change after closing.
What is a floor?
A floor is the minimum rate for which the interest rate can adjust down.
If my credit score is low, how can I raise it?
Paying your bills on time, reducing your credit balances, and trying to not apply for credit too often are all ways that you can raise your FICO score.
Your mortgage is like a reverse investment. Keep in mind that there’s risk involved and make sure you consider all of your options. Like any other investment plan, you should have some idea of how you’ll want (or need) your investment to perform over a period of time in order to reach your goals. There are many options, each performing differently, each with different risks and rewards. Just as the right investment for your needs can make you money, choosing the right mortgage for your needs can save you money.Get a Quick Quote