What Is an Adjustable-Rate Mortgage (ARM)?
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. With an adjustable-rate mortgage, the initial interest rate is fixed for a period of time. After that, the interest rate 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.
- An adjustable-rate mortgage (ARM) is a type of mortgage in which the interest rate applied to the outstanding balance varies throughout the life of the loan.
- Adjustable-rate mortgages 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 home buyers who are planning keep the loan for a limited period of time and can afford any potential increases in their interest rate.
Understanding an Adjustable-Rate Mortgage (ARM)
Typically an ARM is expressed as two numbers. In most cases, the first number indicates the length of time the fixed-rate is applied to the loan.
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 adjusts every five years.
If you're considering an adjustable-rate mortgage, you can compare different types of ARMs using a mortgage calculator.
Indexes vs. Margins
At the end of the initial fixed-rate period, ARM interest rates will become variable (adjustable), and will fluctuate based on a 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 rate on short-term U.S. Treasuries, or the Fed Funds 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.
ARM vs. Fixed Interest Mortgage
Unlike adjustable-rate mortgages, 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, homeowners with fixed-rate mortgages can refinance, paying off their old loan with one at a new, lower rate.
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 you 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 your lender is changing. With negative amortization, the amount you owe can continue to increase, even as you make the required monthly payments.