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What is the Downside of an Adjustable Rate Mortgage (ARM)?

What is the Downside of an Adjustable Rate Mortgage (ARM)?

    Adjustable Rate Mortgages (ARMs) typically have a fixed interest rate for a set period of time, called the fixed rate or "teaser" period, which is usually the first 3, 5, 7 or 10 years of the mortgage.  Following the fixed rate period, the loan converts into an annual (or semi-annual) adjustable mortgage for the remainder of the mortgage term, which is called the adjustable rate period.  During the adjustable rate period the interest rate and monthly mortgage payment for an ARM can change and potentially increase significantly.  In the case of a 7/1 ARM, the interest rate is fixed for the first seven years of the mortgage and then is subject to adjust (and potentially increase) annually for the remaining 23 years of the mortgage.

  • FREEandCLEAR Mortgage Instructional Video

    Adjustable Rate Mortgage (ARM) Overview Instructional Video

  • Example: Worst Case Scenario for an Adjustable Rate Mortgage (ARM)
  • Simply put, the downside of an ARM is the risk that your interest rate and monthly mortgage payment increase suddenly and significantly during the adjustable rate period.  For example, economic factors could cause a spike in interest rates that causes your monthly payment to jump suddenly.  The example below compares the worst cast scenario for a 7/1 ARM to a 30 year fixed rate mortgage to illustrate this concept.  Our ARM worst case scenario example uses the following assumptions:

Key Assumptions

Adjustable Rate Mortgage (ARM)

Mortgage amount $380,000 Index 1 Year LIBOR
Mortgage term 30 years Margin 2.250%
Fixed rate period 7 years Initial adjustment cap 5.000%
Fixed period interest rate 2.750% Subsequent adjustment cap 2.00%
Adjustment Period Annual Life cap 5.00%

30 Year Fixed Rate Mortgage

Mortgage amount $380,000
Mortgage term 30 years
Interest Rate 4.000%

    The example uses a 7/1 ARM so the interest rate and monthly payment are fixed for the first seven years of the loan and then subject to change and increase in year eight and for the remaining 23 years of the loan.  The initial fixed period or teaser interest rate for the first seven years of the ARM is 2.750%.  The ARM has a maximum interest rate of 7.750% based on adding the life cap (5.000%) to the initial fixed period rate (2.750%).  The fixed rate mortgage is much simpler with a 4.000% interest rate over the 30 year term of the mortgage.

    The chart below compares the monthly mortgage payments for the ARM (red line) and fixed rate mortgage (blue line) over the 30 year terms for both mortgages.  During the first seven years, the fixed rate or "teaser" period of the ARM, the interest rate of 2.750% and monthly mortgage payment of $1,551 for the ARM are lower than the interest rate of 4.000% and payment of $1,814 for the fixed rate mortgage.

    As illustrated by the chart below, beginning in year eight, the interest rate for the ARM increases significantly to 7.750%, the maximum possible increase at the first adjustment period.  In this worst case scenario, the interest rate remains at 7.750% for the remaining 23 years of the ARM, the adjustable rate period.  Based on the higher interest rate, the monthly payment for the ARM increases to $2,465 for the remainder of the loan as compared to the $1,814 constant monthly payment for the fixed rate mortgage.

    According to this example, in addition to paying a much higher monthly payment for 23 years of the mortgage, the ARM requires the borrower to pay $157,584 more in total interest expense over the life of the loan as compared to the fixed rate mortgage.  Although this example is unlikely and represents the absolute worst case scenario, it does an excellent job of highlighting the downside of an ARM.  

  • CalculatorUse our ADJUSTABLE RATE MORTGAGE CALCULATOR to review the worst case scenario for any ARM
Monthly Mortgage Payment
  • Fixed Rate Mortgage
  • Adjustable Rate Mortgage
$2,600 $2,200 $1,800 $1,400 $1,000

ARM Fixed Rate Period

Interest Rate: 2.750% Monthly Payment: $1,551

Fixed Rate Mortgage

Interest Rate: 4.000% Monthly Payment: $1,814

Total Interest Expense

ARM: $430,624 Fixed Rate Mortgage: $273,040

ARM Adjustable Rate Period

Interest Rate: 7.750% Monthly Payment: $2,465
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