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What Borrowers Should Know About Adjustable Rate Mortgages (ARMs)
Adjustable Rate Mortgage Basics
With an adjustable rate mortgage (ARM) your interest rate and monthly payment are fixed for the first one, three, five, seven or ten years of the loan and then subject to change and potentially increase annually or semi-annually over the remainder of the loan term. ARMs are often referred to as 3/1, 5/1, 7/1 or 10/1 ARMs with the first number indicating the length of the initial fixed rate period and the second number indicating how frequently the interest rate can change during the adjustable rate period. For example, with a 7/1 ARM, the interest rate and monthly mortgage payment are fixed for the first seven years of the loan and then subject to change on an annual basis for the remaining 23 years of the mortgage. Most adjustable rate mortgages have 30 year loan terms.
The Interest Rate for an Adjustable Rate Mortgage
The interest rate for an adjustable rate mortgage during the initial fixed rate period is set by the lender based on market conditions and negotiations with the borrower. The interest rate during the adjustable rate period is called the fully-index rate and is determined by adding the ARM index to the ARM margin. The ARM margin is a set interest rate, usually between between 2.0% and 3.0%, that does not change over the course of your mortgage. The ARM index is an underlying interest rate, such as LIBOR or the treasury rate, that fluctuates based on economic factors. Because you add the index to the margin to determine your mortgage rate, if the ARM index increases, your mortgage rate increases but if the index decreases, your rate goes down. The fully-indexed rate is used to calculate your monthly mortgage payment for an ARM so an increase in that rate increases your payment. ARMs use adjustment caps that limit the increase in interest rate at the first adjustment period, subsequent adjustment periods and over the life of the mortgage. The life cap for an adjustable rate mortgage is usually 5.0%, so if your initial interest rate is 2.750%, the maximum interest rate you could pay over the life of the loan is 7.750%.
Advantages of an Adjustable Rate Mortgage
Advantages of an ARM include a lower initial interest rate as compared to a fixed rate mortgage and lower initial monthly mortgage payment. The lower initial payment and interest rate also mean that borrowers can typically afford a larger mortgage with an ARM. Adjustable rate mortgages can also be a good option for borrowers in a high interest rate environment if you think mortgage rates will go down in the future. In that scenario you pay a lower interest rate initially and then you benefit further when your interest rate and payment decline if rates drop in the future. Predicting interest rates is highly challenging and exposes borrowers to significant risk.
Disadvantages of an Adjustable Rate Mortgage
Disadvantages of an adjustable rate mortgage include the possibility that your mortgage rate and monthly payment spike in the future. With some ARMs your interest rate can increase by 50% or more at any adjustment period which would cause your mortgage payment to increase significantly. In general, ARMs are better suited for borrowers with a higher tolerance for risk or who are going to own their home for a shorter period of time (less than the length of the fixed rate period of the loan). Borrowers who value peace of mind and certainty should avoid the potential payment shock associated with an ARM.
More FREEandCLEAR Mortgage Resources
Review our in-depth explanation of how an adjustable rate mortgage works including key terminology, borrowers benefits as well as informative charts and examples
Understand the risks of an adjustable rate mortgage (ARM) including potential payment shock if interest rates spike
Review the pros and cons of adjustable rate, fixed rate and interest only mortgages to determine the mortgage program that is right for you
Review adjustable rate mortgage rates in your area based on initial interest rate, discount points, credit score and other inputs. Comparing ARM mortgage rates from multiple lenders enables you to find the mortgage with the best terms