What is an Adjustable-Rate Mortgage (ARM)?

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Definition:

An adjustable-rate mortgage is a type of home loan agreement where the interest rate can change periodically over the life of the loan.

🤔 Understanding adjustable-rate mortgages

Adjustable-rate mortgages (ARMs) have interest rates that vary over the years. Also referred to as variable-rate mortgages, this type of loan agreement starts at an introductory interest rate, and then the rate can increase or decrease in the future. Adjustable-rate mortgages aren’t without their risks — You could see your interest rate go down, but you could also see your rate increase drastically. However, these mortgages do come with rate and payment caps, meaning there’s a limit as to how much your mortgage payment could increase. The interest rate of adjustable-rate mortgages is tied to a financial index such as that of Treasury bills or the London Interbank Offered Rate (LIBOR). The other primary type of mortgage is a fixed-rate mortgage, in which the interest remains the same for the life of the loan agreement.

Example

Suppose you’re about to buy your first house, so you’re shopping around for a mortgage. You are trying to decide between an adjustable-rate and fixed-rate mortgage. A lending institution is offering you a lower starting rate for an adjustable-rate mortgage than a fixed-rate one, and you feel confident you’ll pay it off early. You decide to gamble on the adjustable-rate mortgage, hoping interest rates don’t increase too much while you’re paying off your loan.

Takeaway

An adjustable-rate mortgage is like if your landlord could change the price of your rent…

When you sign a lease, you’re locking in a particular price for rent for a specific amount of time (often a year). Your landlord can’t just change the cost of rent based on outside factors. If they could, it would be similar to an adjustable-rate mortgage. While a fixed-rate mortgage guarantees you a consistent monthly payment, an adjustable-rate one can change with the rate it’s tied to.

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How does an ARM work?

When you take out a traditional fixed-rate mortgage, your interest rate will stay the same for the entirety of your mortgage — unless you refinance. That is not the case with an adjustable-rate mortgage (ARM).

Each ARM loan agreement has an introductory period during which your interest rate does not change. Depending on your specific mortgage, this period could last anywhere from one to 10 years. After that initial rate period, your interest rate can change. Each mortgage also has a predetermined number of times per year that the interest rate can change.

ARMs appear as two numbers. For example, you might have a 5/1 ARM, which is the most popular on the market. The first number is your fixed-rate period, which in this case is five years. The second number is the number of times per year that your interest rate can change. A 5/1 agreement indicates that after the first five years, your rate could change once per year for the remainder of the term.

To prevent your interest rate from increasing too fast, most ARMs have caps on them. The caps can mean a few different things. First, you might have a periodic rate cap on how much your interest can change from year to year. You might also have a lifetime rate cap, which is how much your interest can increase over the entire life of your mortgage. Finally, you might have a payment cap — This is the maximum amount that your monthly payment can rise over the life of your loan.

Most mortgage lenders offer the option of ARMs. Depending on your situation, you might also qualify for a Federal Housing Administration (FHA) ARM. An FHA loan agreement is one designed for high-risk borrowers (meaning those with low credit scores or low incomes). The FHA doesn’t lend the money for these loans. Instead, the FHA insures them and reimburses the lender for its losses if the homeowner can’t make their payments.

What are the types of ARMs?

There are several different types of adjustable-rate mortgages (ARMs). The hybrid ARM is the most common, but depending on the lender, you may be able to get one of the other options as well.

Hybrid ARM

The hybrid ARM is the most common — This is the one that your bank or credit union typically advertises when they talk about ARMs. The term hybrid refers to the fact that there are a particular number of years where your interest rate is fixed, while it is adjustable for the rest of the life of the mortgage

Each hybrid ARM will have two key features: the first is the number of years during which your interest rate is fixed. The second feature is the number of times per year that your interest rate can adjust after that fixed period.

Interest-Only ARM

An interest-only ARM is one that allows you to pay only the interest on your loan for a predetermined number of years. Then for the rest of the life of the mortgage, you pay both the principal and interest every month.

This type of mortgage is less popular than hybrid loans. The problem with interest-only loans is that after the introductory period where you’re only paying interest, your payments increase substantially.

With this type of loan, the interest-only period typically aligns with the introductory period. So the first time your interest rate changes, you’d also start making your full monthly payment.

This type of mortgage can be beneficial for a homeowner who needs a lower monthly payment in the early years but is confident they’ll have more money to pay later.

One example could be a doctor who has an interest-free period that lines up with the time they’re in residency, and they’ll be making significantly more money when it’s time to make the full monthly payments. It could also be someone who is purchasing the house to renovate and resell — They know they won’t own the home longer than the interest-free period.

Payment Option ARM

Payment option ARMs are the least common type, and many lenders don’t offer them. The critical feature of this type of ARM is that the borrower gets to decide how much they pay each month for a set period of time.

This type of ARM carries an incredibly high level of risk for the lender. Payment option ARMs helped contribute to the mortgage crisis (interest-only loans were also a contributing factor) because people had taken out payment option ARMs, and they weren’t able to pay them back.

The problem with this type of loan is that they allow borrowers to pay less than what they really owe every month. But then whatever they don’t pay just gets tacked back onto their balance, with interest, and the size of their mortgages may continue to grow rather than shrink.

This type of mortgage is a lot harder to find today. The people who might benefit from this type of loan are real estate investors making a short term investment.

How is an ARM calculated?

One of the critical characteristics of an ARM is the adjustable interest rate. But how are those new rates calculated? Depending on the bank or credit union you got your mortgage from, they may use a different standard interest rate. Each mortgage will be tied to a specific financial index, which is the indicator banks use to determine the rates on ARMs.

There are a few different indexes that lenders might use to determine ARM rates:

  • London Interbank Offered Rate (LIBOR): LIBOR is a daily-calculated rate that represents the interest rate that large international banks are willing to lend each other money.
  • One-Year Treasury bills: A Treasury bill is a short term debt security that the U.S. Treasury issues. The maturity yield on one of these bills is one of the index rates banks use for ARMs.
  • 11th District cost of funds index (COFI): COFI is an average of the interest rates on deposit accounts in western states.

Your mortgage lender will use one of these financial indexes to determine the rate on your ARM, but they don’t just use the same number. Each ARM comes with a margin, which is usually based on factors such as your creditworthiness. The margin is the extra percentage amount your bank will tack onto the index rate to come up with your ARM rate. That calculation looks like this:

Adjustable-Rate Mortgage Rate = Index Rate + Margin

Your lender typically sets the margin ahead of time, and you might be able to negotiate with your lender to come down to a lower margin.

The rate for ARMs changes all the time, but according to the Federal Reserve Bank of St. Louis, the average rate for a 5/1 ARM as of March 19, 2020 was 3.11%.

What are the advantages and disadvantages of an ARM? Are they a good idea?

Advantages

There are definitely some advantages to adjustable-rate mortgages (ARMs). First, they can offer low payments during the introductory fixed-rate period. You may be able to get a lower interest rate on an ARM than a fixed-rate mortgage, and you have the guarantee of a few years of smaller payments.

Another perk to ARMs is that depending on what’s going on with the economy, your rate may decrease. Most often, you hear warnings against increasing rates with ARMs, but you could experience the opposite. If your fixed-rate period is coming to an end and interest rates have gone down, you might have the pleasant surprise of lower monthly payments.

In the case that your interest rate increases, as is entirely possible, ARMs do have the advantage of having safeguards in place to make sure your rate and monthly payment don’t spiral completely out of control.

Disadvantages

ARMs can be the right choice for some people, but they have their downsides as well. The primary concern with this type of mortgage is that your interest rate, and therefore your monthly payment, can increase significantly.

Depending on the size of your mortgage, this could be the difference in hundreds of dollars per month. If you’re part of a household that is already living paycheck-to-paycheck, this increasing payment could be the difference between whether or not you’re able to pay your mortgage.

Another problem with ARMs is that many people use them under the assumption that they’ll refinance or sell before the fixed-rate period ends. But things don’t always go as planned, and you might find yourself unable to do that. Then you’re stuck with a higher monthly payment than you thought.

Another thing to look out for with ARMs is that some come with a prepayment penalty. This penalty could apply if you pay your mortgage off faster than you have to. But it could also apply in cases where you sell or refinance early in the life of the mortgage.

Who is an ARM right for?

Despite the risks that come with adjustable-rate mortgages (ARMs), they might be the right choice for some people. An ARM could be a preferable choice for homebuyers who plan to either refinance their mortgage or sell the home before the fixed-rate period ends.

First, this could be a homeowner who plans to stay in the home long-term but knows, for whatever reason, that they’ll be refinancing at some point in the next few years (depending on the length of the fixed-rate period).

An ARM could also be a good option for real estate investors who don’t plan to keep a home very long. They might find that the interest rate they get on an ARM at the time is lower than what they can get on a fixed-rate mortgage. Maybe they’re planning to fix up the home and sell within a year or two for a profit.

What is the difference between an ARM and a fixed-rate mortgage, and which is better?

A fixed-rate mortgage is one where you lock in your interest rate at the time of purchase, and it doesn’t change over the life of the mortgage. These mortgages often come in the form of 15- or 30-year loan agreements. Because your interest rate does not change, your monthly payment stays the same for the entire 15 or 30 years.

Fixed-rate mortgages are beneficial because they provide a lot of stability. Many people like the comfort of knowing how much they’ll have to pay every month. But they can put you at a disadvantage in a situation where interest rates are going down, and you can’t take advantage of the decline (unless you refinance).

There’s no hard and fast rule as to which type of loan is better. It depends mainly on your financial situation and what you plan to do with the house over the next five to 10 years. Both adjustable-rate mortgages and fixed-rate mortgages can be right for specific circumstances.

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