How an Adjustable Rate Mortgage (ARM) Works
- Adjustable Rate Mortgage (ARM) Overview
- Use our ADJUSTABLE RATE MORTGAGE CALCULATOR to calculator the monthly payment and worst case scenario for an ARM
Watch our "Adjustable Rate Mortgage (ARM) Overview" instructional video
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, and then convert into an annual or semi-annual (adjusts every six months) 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. These mortgages are called 3/1, 5/1, 7/1 and 10/1 ARMs. ARMs typically have 30 year terms. In the case of a 3/1 ARM, the interest rate is fixed for the first three years of the mortgage and then is subject to adjust annually for the remaining 27 years of the mortgage.
The most important thing to understand about an ARM is that the interest rate can change over the life of the mortgage. With an ARM, the borrower faces the risk of having to pay a higher monthly mortgage payment in the event that interest rates increase over the course of the mortgage. Conversely, if interest rates decrease, then the borrower could potentially pay a lower monthly payment.
Teaser Rate for an Adjustable Rate Mortgage (ARM)
Interest rate pricing for the initial fixed rate period is set by the lender and is typically lower than the interest rate for a 30 year fixed rate mortgage. The initial interest rate for an ARM is often referred to as the "teaser rate" because the lower rate and monthly mortgage payment entices borrowers. This is the primary reason to choose an ARM -- because the interest rate and mortgage payment are lower than a fixed rate mortgage during the initial period of the loan. Another reason to select an ARM is if you think interest rates are going to decline significantly in the future although ARMs also carry the risk that your mortgage payment will increase if interest rates rise in the future.
Fully-Indexed Rate for an Adjustable Rate Mortgage (ARM)
The interest rate for the adjustable rate period, which follows the fixed rate period, is called the fully-indexed rate. The fully-indexed rate is calculated by adding the ARM index to the ARM margin. The index is an underlying rate that can change. Lenders typically use the 1 year LIBOR as the ARM index but be sure to confirm what index your lender uses. Simply put, LIBOR represents the interest rate that banks charge each other to borrow money and changes with fluctuations in the economy. The ARM margin is a set interest rate amount that does not change over the term of the loan. The ARM margin is typically 2.0% - 3.0%. So if the 1 year LIBOR is 1.000% and the ARM margin is 2.250% then the fully-indexed rate is 3.250%.
The fully-indexed rate is re-calculated on an annual basis for the remainder of the mortgage term following the fixed rate period and will change with any fluctuations in the ARM index. So in the case of a 3/1 ARM, the fully-indexed rate adjusts on an annual basis for the final 27 years of the mortgage. The fully-indexed rate is calculated on the first day of the month prior to the adjustment date for the mortgage. So if the fully-indexed rate is scheduled to adjust on October 1st, then the rate is calculated on September 1st.
Adjustment Caps for an Adjustable Rate Mortgage (ARM)
ARMs have an initial adjustment cap that limits the change in the interest rate at the time of the first adjustment period. The initial adjustment cap is typically 2.0% or 5.0%. ARMs have a subsequent adjustment cap that limits the change in interest rate in any adjustment period following the initial adjustment. ARMs also have a life cap which limits the maximum increase in interest rate over the term of the mortgage. The typical life cap for an ARM is 5.0% which means the fully indexed rate cannot exceed the initial fixed period interest rate by more than 5.0%.
Adjustable Rate Mortgage (ARM) Key Items
The table below summarizes the key items to focus on in evaluating an adjustable rate mortgage (ARM).
|Fixed Rate Period||
|Fixed Period Interest Rate||
|Adjustable Rate Period||
|Initial Adjustment Cap||
|Subsequent Adjustment Cap||
- Why Select an Adjustable Rate Mortgage (ARM)
- Review Downside of an Adjustable Rate Mortgage to understand the risks for an ARM
- Adjustable Rate Mortgage (ARM) Rates
- Example: Comparing Monthly Mortgage Payments for an ARM to a Fixed Rate Mortgage
Where You Can Find Information About Your Adjustable Rate Mortgage (ARM)
Lenders are required to provide a Loan Estimate that outlines key mortgage features, including ARM terms, within three business days of a borrower submitting a loan application. The Loan Estimate for an ARM will indicate if, when and by how much the interest rate and monthly payment can change (page 1). The bottom of page 2 of the LE has an Adjustable Payment (AP) table that indicates a range of estimated mortgage payments at the first adjustment period, how often the payment can change after the first adjustment (adjustment interval) and the maximum possible payment amount and when the maximum payment can occur. The bottom of page 2 of the Loan Estimate also has an Adjustable Interest Rate (AIR) table that indicates the initial interest rate, the index and margin, the minimum and maximum interest rate, when the rate can initially adjust and how frequently it can adjust thereafter (adjustment interval); and, the limit on the change/increase in interest rate at the first adjustment period (initial cap) and subsequent adjustment periods (life cap). Additionally, all of the key terms of the ARM including initial interest rate, index and margin are set forth in the mortgage note and the ARM addendum attached to the mortgage note.
With so many moving parts and so much complexity, you may ask why would someone would select an adjustable rate mortgage (ARM) for their mortgage? The answer is because the initial "teaser" interest rate and monthly mortgage payment for an ARM during the fixed rate period are typically lower than the interest rate and monthly payment for a fixed rate mortgage. The lower initial rate and monthly payment may also enable you to qualify for a larger mortgage amount.
So if you know that you are only going to own the property during the fixed rate period then an ARM may be the right mortgage program for you. That way you benefit from the lower monthly mortgage payment during the fixed rate period but you are not exposed to a potential increase in interest rate and monthly payment during the adjustable rate period of the loan.
The other reason to select an ARM is if you think that interest rates are going to decline significantly in the future. If interest rates decline during the adjustable rate period of your ARM then your monthly mortgage payment will decline as well. Applying the same rationale, although it is somewhat counter intuitive, ARMs can be a good option for borrowers in a high interest rate environment if you think rates will eventually decline over time. Predicting interest rates can be very challenging, especially over the 30 year term of a typical ARM, so this strategy exposes the borrower to meaningful risk.
The interest rate you pay on an ARM depends on several factors including your credit score, loan-to-value (LTV) ratio, fixed rate period length and mortgage type. Additionally, adjustable rate mortgage rates tend to be lower than the interest rate for a fixed rate mortgage or interest only mortgage. Adjustable rate mortgages are provided by traditional lenders such as banks, mortgage banks, mortgage brokers and credit unions. Borrowers should shop multiple lenders to find the ARM with the lowest interest rate and fees. Click on lenders in the table below or INTEREST RATES to compare adjustable rate mortgage interest rates.
The chart below compares the monthly mortgage payments for a $380,000 mortgage for 3/1, 5/1, 7/1 and 10/1 ARMs with a 30 year fixed rate mortgage. Please note that for the ARMs, the chart shows the interest rate and monthly mortgage payment for the initial fixed rate period. Both the interest rate and mortgage payment are subject to change following the fixed rate period. As the chart illustrates, an ARM typically allows borrowers to save money on their monthly mortgage payment during the initial fixed rate period in comparison to a fixed rate mortgage.
Monthly Payment for a $380,000 Mortgage
- $1,5013/1 ARM
- $1,5265/1 ARM
- $1,5517/1 ARM
- $1,62810 / 1 ARM
- $1,76030 Year Fixed Rate
- Adjustable Rate Mortgage (ARM) Teaser or Fixed Rate Period
The length of the fixed rate, or teaser, period for an adjustable rate mortgage (ARM) directly affects the interest rate during the fixed rate period. The shorter the fixed rate period, the lower the interest rate and the lower the monthly mortgage payment. The trade-off of a shorter fixed rate period and lower interest rate is that the adjustable rate period is longer, which exposes the borrower to more risk that the ARM interest rate will increase and remain higher for a longer period of time.
The chart below demonstrates how the length of the fixed rate period impacts the initial "teaser" interest rate for an ARM. As illustrated by the chart, the shorter the fixed rate period, the lower the interest rate.
- 2.500%3/1 ARM
- 2.625%5/1 ARM
- 2.750%7/1 ARM
- 3.125%10 / 1 ARM
- 3.750%30 Year Fixed Rate
- How Amortization Works for an Adjustable Rate Mortgage (ARM)
- Related FREEandCLEAR Resources
Both fixed rate mortgages and ARMs amortize, which means the monthly payment is comprised of both principal and interest payments and that the loan is re-paid in full with the final payment. The difference in amortization between a fixed rate mortgage and an ARM is that the ARM loan balance re-amortizes over the remaining term of the mortgage every time the interest rate adjusts. Because an ARM’s interest rate changes on an annual or semi-annual basis during the adjustable rate period, the loan balance must be re-amortized, using the fully-indexed rate, every year over the remaining term of the loan.
For example, a 3/1 ARM first adjusts at the end of year three. The monthly mortgage payment beginning in year four is based on the loan balance, fully-indexed rate and an amortization period of 27 years, the remaining term of the mortgage. At the end of year four, the mortgage payment is based on an amortization period of 26 years, and so on.
The re-amortization of an ARM is in contrast to a fixed rate mortgage which has a set amortization period over the life of the loan. For example, the amortization period for a 30 year fixed rate mortgage is set at 30 years. What does this difference in amortization mean for the borrower?
It means that a borrower with an ARM may have a higher monthly mortgage payment than a borrower with a fixed rate mortgage because the remaining mortgage balance is amortized over a shorter period of time. Every time an ARM adjusts, a potential increase in interest rate and the re-amortization of the mortgage balance over a shorter period of time can both contribute to an increase in monthly mortgage payment which is an added risk for the borrower.