What Is an Adjustable-Rate Mortgage (ARM)?
An adjustable-rate mortgage (ARM) is a home loan with a variable interest rate. With an ARM, the initial interest rate is fixed for a period of time. After that, the interest rate applied on the outstanding balance resets periodically, at yearly or even monthly intervals.
ARMs are also called variable-rate mortgages or floating mortgages. The interest rate for ARMs is reset based on a benchmark or index, plus an additional spread called an ARM margin. The typical index that is used in ARMs has been the London Interbank Offered Rate (LIBOR).
- An adjustable-rate mortgage (ARM) is a home loan with an interest rate that can fluctuate periodically based on the performance of a specific benchmark.
- ARMs generally have caps that limit how much the interest rate and/or payments can rise per year or over the lifetime of the loan.
- An ARM can be a smart financial choice for homebuyers who are planning to keep the loan for a limited period of time and can afford any potential increases in their interest rate.
Click Play to Learn All About Adjustable-Rate Mortgages
Understanding an Adjustable-Rate Mortgage (ARM)
When you get a mortgage, you’ll need to repay the borrowed sum over a set number of years as well as pay the lender something extra to compensate them for their troubles and the likelihood that inflation will erode the value of the balance by the time the funds are reimbursed.
In most cases, you’ll be able to choose between keeping this interest rate fixed for the life of the loan or letting it fluctuate up and down. Usually, the initial borrowing costs of an ARM are fixed at a lower rate than what you’d be offered on a comparable fixed-rate mortgage. However, after that point, the interest rate that affects your monthly payments could move higher or lower, depending on the state of the economy and the general cost of borrowing.
Types of ARMs
ARMs generally come in three forms: Hybrid, interest-only (IO), and payment option. Here’s a quick breakdown of each.
Hybrid ARMs offer a mix of a fixed- and adjustable-rate period. With this type of loan, the interest rate will be fixed at the beginning and then begin to float at a predetermined time.
This information is typically expressed in two numbers. In most cases, the first number indicates the length of time that the fixed rate is applied to the loan, while the second refers to the duration or adjustment frequency of the variable rate.
For example, a 2/28 ARM features a fixed rate for two years followed by a floating rate for the remaining 28 years. In comparison, a 5/1 ARM has a fixed rate for the first five years, followed by a variable rate that adjusts every year (as indicated by the number one after the slash). Likewise, a 5/5 ARM would start with a fixed rate for five years and then adjust every five years.
You can compare different types of ARMs using a mortgage calculator.
Interest-only (I-O) ARM
It’s also possible to secure an interest-only (I-O) ARM, which essentially would mean only paying interest on the mortgage for a specific time frame—typically three to 10 years. Once this period expires, you are then required to pay both interest and the principal on the loan.
These types of plans appeal to those keen to spend less on their mortgage in the first few years so that they can free up funds for something else, such as purchasing furniture for their new home. Of course, this advantage comes at a cost: The longer the I-O period, the higher your payments will be when it ends.
A payment-option ARM is, as the name implies, an ARM with several payment options. These options typically include payments covering principal and interest, paying down just the interest, or paying a minimum amount that does not even cover the interest.
Opting to pay the minimum amount or just the interest might sound appealing. However, it’s worth remembering that you will have to pay the lender back everything by the date specified in the contract and that interest charges are higher when the principal isn’t getting paid off. If you persist with paying off little, then you’ll find your debt keeps growing—perhaps to unmanageable levels.
How the Variable Rate on ARMs Is Determined
At the end of the initial fixed-rate period, ARM interest rates will become variable (adjustable) and will fluctuate based on some reference interest rate (the ARM index) plus a set amount of interest above that index rate (the ARM margin). The ARM index is often a benchmark rate such as the prime rate, the LIBOR, the Secured Overnight Financing Rate (SOFR), or the rate on short-term U.S. Treasuries.
Although the index rate can change, the margin stays the same. For example, if the index is 5% and the margin is 2%, the interest rate on the mortgage adjusts to 7%. However, if the index is at only 2% the next time that the interest rate adjusts, the rate falls to 4% based on the loan’s 2% margin.
The interest rate on ARMs is determined by a fluctuating benchmark rate that usually reflects the general state of the economy and an additional fixed margin charged by the lender.
Adjustable-Rate Mortgage vs. Fixed Interest Mortgage
Unlike ARMs, traditional or fixed-rate mortgages carry the same interest rate for the life of the loan, which might be 10, 20, 30, or more years. They generally have higher interest rates at the outset than ARMs, which can make ARMs more attractive and affordable, at least in the short term. However, fixed-rate loans provide the assurance that the borrower’s rate will never shoot up to a point where loan payments may become unmanageable.
With a fixed-rate mortgage, monthly payments remain the same, although the amounts that go to pay interest or principal will change over time, according to the loan’s amortization schedule.
If interest rates in general fall, then homeowners with fixed-rate mortgages can refinance, paying off their old loan with one at a new, lower rate.
Lenders are required to put in writing all terms and conditions relating to the ARM in which you’re interested. That includes information about the index and margin, how your rate will be calculated and how often it can be changed, whether there are any caps in place, the maximum amount that you may have to pay, and other important considerations, such as negative amortization.
Is an Adjustable-Rate Mortgage Right for You?
An ARM can be a smart financial choice if you are planning to keep the loan for a limited period of time and will be able to handle any rate increases in the meantime.
In many cases, ARMs come with rate caps that limit how much the rate can rise at any given time or in total. Periodic rate caps limit how much the interest rate can change from one year to the next, while lifetime rate caps set limits on how much the interest rate can increase over the life of the loan.
Notably, some ARMs have payment caps that limit how much the monthly mortgage payment can increase, in dollar terms. That can lead to a problem called negative amortization if your monthly payments aren’t sufficient to cover the interest rate that your lender is changing. With negative amortization, the amount that you owe can continue to increase, even as you make the required monthly payments.
Why is an adjustable-rate mortgage (ARM) a bad idea?
Adjustable-rate mortgages (ARMs) aren’t for everyone. Yes, their favorable introductory rates are appealing, and an ARM could help you to get a larger loan for a home. However, it’s hard to budget when payments can fluctuate wildly, and you could end up in big financial trouble if interest rates spike, particularly if there are no caps in place.
How are ARMs calculated?
Once the initial fixed-rate period ends, borrowing costs will fluctuate based on a reference interest rate, such as the prime rate, the London Interbank Offered Rate (LIBOR), the Secured Overnight Financing Rate (SOFR), or the rate on short-term U.S. Treasuries. On top of that, the lender will also add its own fixed amount of interest to pay, which is known as the ARM margin.
When were ARMs first offered to homebuyers?
ARMs have been around for several decades, with the option to take out a long-term house loan with fluctuating interest rates first becoming available to Americans in the early 1980s.
Previous attempts to introduce such loans in the 1970s were thwarted by Congress, due to fears that they would leave borrowers with unmanageable mortgage payments. However, the deterioration of the thrift industry later that decade prompted authorities to reconsider their initial resistance and become more flexible.