Adjustable-Rate Mortgage (ARM)

An adjustable-rate mortgage (ARM) is a type of home loan where the interest rate applied on the outstanding balance varies throughout the life of the loan. This contrasts with a fixed-rate mortgage, where the interest rate remains constant over the loan term. ARMs are characterized by an interest rate that changes periodically—typically in relation to an index—and payments that may go up or down accordingly. Because of this variability, ARMs carry both potential benefits and risks for borrowers.

How Adjustable-Rate Mortgages Work

Initial Fixed-Rate Period

ARMs usually begin with an initial period during which the interest rate remains fixed. This period can range from a few months to several years. Common initial fixed periods include 3, 5, 7, or 10 years. This allows borrowers to enjoy lower initial interest rates compared to fixed-rate mortgages.

Adjustment Period

After the initial fixed-rate period, the ARM enters the adjustment period. During this time, the interest rate can change at regular intervals, such as every month, every six months, every year, or another specified period, depending on the loan terms. The adjustment period will continue until the loan is paid off, sold, or refinanced.

Index and Margin

The new interest rate during the adjustment period is determined by adding a margin to an index rate. Common indices used for ARMs include:

• LIBOR (London Interbank Offered Rate)
• COFI (Cost of Funds Index)
• CMT (Constant Maturity Treasury)
• SOFR (Secured Overnight Financing Rate)

The margin is a percentage added to the index rate, which remains fixed for the life of the loan.

Rate Caps

Rate caps limit how much the interest rate can change at any adjustment. Typical caps include:

• Initial Adjustment Cap: Limits how much the interest rate can increase the first time it adjusts after the fixed period.
• Subsequent Adjustment Cap: Limits how much the interest rate can change at each subsequent adjustment period.
• Lifetime Adjustment Cap: Limits the total increase in the interest rate over the life of the loan.

Payment Caps

Some ARMs may include a payment cap, which limits how much the monthly payment can increase at each adjustment regardless of how much the interest rate increases. This could lead to negative amortization, where the loan balance increases because the payments are not covering the interest charges.

Types of Adjustable-Rate Mortgages

Various types of ARMs are structured based on different terms and adjustment rules:

Hybrid ARMs

Hybrid ARMs combine features of fixed-rate mortgages and adjustable-rate mortgages. For example, a 5/1 ARM has a fixed rate for the first five years and then adjusts annually afterward.

Interest-Only ARMs

Interest-only ARMs allow borrowers to pay only the interest for a specified time, often the initial fixed-rate period. After that, payments are recalculated to include both principal and interest, sometimes leading to a significant payment increase.

Payment-Option ARMs

Payment-option ARMs give borrowers multiple payment options each month, such as a minimum payment, an interest-only payment, or a fully amortizing payment. These options provide flexibility but can result in negative amortization.

Pros and Cons of ARMs

Advantages

• Lower Initial Rates: ARMs often start with lower rates than fixed-rate loans, making them more affordable initially.
• Flexibility: Beneficial for borrowers who plan to sell or refinance before the adjustment period begins.
• Rate Decrease Potential: If market rates decline, ARM rates and payments might also decrease.

Disadvantages

• Uncertainty: Future rate and payment levels are uncertain, making budgeting more difficult.
• Complexity: ARMs have more complex terms and features, requiring borrowers to understand all adjustment rules.

Who Should Consider an ARM?

ARMs may be appropriate for:

• Borrowers who plan to move before the initial rate period ends.
• Those expecting their income to increase.
• Individuals in high-interest-rate environments anticipating rate declines.

How to Compare ARMs

Annual Percentage Rate (APR)

Consider the APR, which reflects the ARM’s total borrowing cost, including initial rates and future adjustments. A lower APR can indicate a lower overall cost.

Caps and Index

Understand the potential rate increases by examining indexed caps and margins. Some indices are more volatile, affecting how much and how fast rates can change.

Loan Documentation

Review the Loan Estimate and Closing Disclosure for complete terms and conditions. These documents outline the specifics of both interest rate adjustments and payment caps.

Conclusion

Adjustable-rate mortgages are a complex but potentially advantageous financial product for specific types of borrowers. They offer initial lower rates and flexibility but come with inherent risks due to interest rate variability. A sound understanding of the terms, potential changes in payments, and how they fit a borrower’s financial situation is essential. Those considering ARMs should carefully weigh these factors and consult with a mortgage advisor to make an informed decision.