An adjustable-rate mortgage (ARM) is a type of mortgage in which the interest rate applied on the outstanding balance varies throughout the life of the loan. Normally, the initial interest rate is fixed for a period of time, after which it resets periodically, often every year or even monthly. The interest rate resets based on a benchmark or index plus an additional spread, called an ARM margin.
Also called a variable-rate or floating rate mortgage, ARMs take a number of different forms.
Typically, ARMs are expressed as two numbers. In most cases, the first number indicates the length of time the fixed-rate is applied to the loan, but there is no set formula defining what the second number indicates. For example, a 2/28 ARM and a 3/27 ARM feature a fixed rate for two or three years, respectively, followed by a floating rate for the remaining 28 or 27 years. In contrast, a 5/1 ARM boasts a fixed rate for five years, followed by a variable rate that adjusts every year (indicated by the one). Similarly, a 5/5 ARM starts with a fixed rate for five years and then adjusts every five years. Contrary to that formula, a 5/6 ARM has a fixed rate for five years and then adjusts every six months. If you're considering an adjustable-rate mortgage, you can compare different types of ARMs using a mortgage calculator.
At the close of the fixed-rate period, ARM interest rates increase or decrease based on an index plus a set margin. In most cases, mortgages are tied to one of three indexes: the maturity yield on one-year Treasury bills, the 11th District cost of funds index, or the London Interbank Offered Rate.
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 the interest rate adjusts, the rate falls to 4%, based on the loan's 2% margin.
In many cases, ARMs come with rate caps that limit how high the rate can be or how drastically the payments can change. 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 can increase over the life of the loan. Finally, there are payment caps that stipulate how much the monthly mortgage payment can increase. Payment caps detail increases in dollars rather than based on percentage points.