The most important thing to know about how an Adjustable Rate Mortgage (ARM) works is that it lives up to its name. The mortgage rate and monthly payment for an ARM can adjust, or change, over the course of the loan; however, that is only the case for part of the mortgage. An ARM is kind of like two mortgages in one -- there is a the initial fixed rate period which is followed by the adjustable rate period. Unlike a fixed rate mortgage when your monthly payment never changes, your payment in year one of an ARM can be very different than your payment in year 25. Adjustable Rate Mortgages amortize which means you pay down a little bit of principal with every payment even though your payment amount may change. Continue reading to learn how an Adjustable Rate Mortgage Works including when your rate and payment can change and the key ARM loan terms borrowers should understand.
As referenced above, an ARM basically has two parts. They have the initial fixed rate or "teaser" period, which is usually the first 3, 5, 7 or 10 years of the mortgage during which your interest rate and monthly payment cannot change. The adjustable rate period of an ARM follows the fixed rate period. During the adjustable rate period your mortgage rate and payment are subject to adjust on an annual or semi-annual basis, and potentially increase significantly, for the remainder of the loan term.
Adjustable Rate Mortgages are usually 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 loan and then subject to adjust annually for the remaining 27 years of the mortgage. There are also 5/5 ARMs when your mortgage rate and payment re-adjust after five years and then are fixed for another five years before the loan moves into the adjustable rate period for the remainder of the term.
The most important point to understand about an Adjustable Rate Mortgage is that the interest rate can change over the life of the mortgage. 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 loan. Conversely, if interest rates decrease, then the borrower could potentially pay a lower monthly payment.
ARMs are much more complicated than fixed rate mortgages. There is a set of loan terms that outline how an Adjustable Rate Mortgage works including when and by how much your mortgage rate and payment can change. We summarize some of the most important ARM terms below.
Teaser Rate for an Adjustable Rate Mortgage
Interest rate pricing for the initial fixed rate period of an ARM is set by the lender and is typically lower than the interest rate for a 30 year fixed rate mortgage. The initial interest rate 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 Adjustable Rate Mortgage -- because the interest rate and monthly payment are lower than a fixed rate mortgage during the initial period of the loan. This also helps you afford a higher mortgage amount. 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 payment will increase if interest rates rise in the future.
Fully-Indexed Rate for an Adjustable Rate Mortgage
The interest rate for the adjustable rate period of an ARM, which follows the fixed rate period, is called the fully-indexed rate. The fully-indexed rate is calculated by adding the index to the 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 the 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 important because it is used to determine your monthly payment for the majority of your mortgage.
The fully-indexed rate is re-calculated on an annual or semi-annual basis for the remainder of the mortgage term following the fixed rate period and changes 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
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%. Subsequent adjustment caps limit the change in mortgage rate in any adjustment period following the initial adjustment. Adjustable Rate Mortgages also have a life cap which limits the maximum increase in interest rate over the term of the loan. 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%. For example, if your initial mortgage rate is 2.500% and the life cap is 5.000%, then the maximum interest rate for your loan is 7.500%.
Because it has so many moving pieces, you should review the table below to learn everything there is to know about an Adjustable Rate Mortgage.
Where You Can Find Information About An Adjustable Rate Mortgage
Lenders are required to provide you a Loan Estimate that outlines key mortgage terms, within three business days of a submitting a loan application. The Loan Estimate for an Adjustable Rate Mortgage indicates if, when and by how much the interest rate and monthly payment can change (page 1). The bottom of page 2 of the Loan Estimate 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 key loan terms including initial interest rate, index and margin are set forth in the ARM addendum attached to your mortgage note.
The interest rate you pay on an Adjustable Rate Mortgage depends on several factors including your credit score, loan-to-value (LTV) ratio, fixed rate period length and mortgage type. Additionally, ARM 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.
The table below compares interest rates and closing fees for five and seven year ARMs. As demonstrated by the table, the shorter the initial fixed rate period, the lower initial interest rate. We recommend that you contact multiple lenders in table to find best ARM loan terms.
With so much complexity, you may ask why would someone would select an Adjustable Rate Mortgage? The answer is because the initial "teaser" interest rate and monthly mortgage payment for an ARM are typically lower than the interest rate and monthly payment for a fixed rate mortgage. The lower initial mortgage rate and monthly payment may also enable you to afford a bigger mortgage.
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 payment during the fixed rate period but you are not exposed to a potential increase in mortgage rate and monthly payment during the adjustable rate period of the loan.
Use our personalized mortgage quote form to review ARM quotes for leading lenders in your area. Our quote feature is free, easy-to-use and requires minimal personal information. Comparing multiple mortgage proposals is the best way to save money on an adjustable rate mortgage.
The other reason to choose an Adjustable Rate Mortgage is if you think that interest rates are going to decline significantly in the future. If interest rates decline during the adjustable rate period then your monthly payment also declines. 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 a 30 year loan term, so this strategy exposes borrowers to meaningful risk.
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 payment are subject to change following the fixed rate period. As the chart illustrates, an Adjustable Rate Mortgage typically allows borrowers to save money on their monthly mortgage payment during the initial fixed rate period in comparison to a fixed rate mortgage.
The length of the fixed rate, or teaser, period for an ARM directly affects your mortgage rate. The shorter the fixed rate period, the lower the interest rate and the lower the monthly 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 your interest rate increases and remains 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 rate.
Both fixed rate and adjustable rate mortgages amortize, which means the monthly payment is comprised of both principal and interest payments and that the loan is paid off 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 every time the interest rate adjusts. Because an ARM‚Äôs 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 or six months over the remainder 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 loan term. 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 Adjustable Rate Mortgage may have a higher monthly mortgage payment than a borrower with a fixed rate mortgage because the remaining loan 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 loan balance can both contribute to an increased monthly payment which is an added risk for borrowers.
Watch our Adjustable Rate Mortgage video tutorial to learn how an ARM works
Adjustable Rate Mortgage (ARM) instructional video
Related FREEandCLEAR Resources
‚ÄúConsumer handbook on adjustable-rate mortgages.‚ÄĚ CFPB. Consumer Financial Protection Bureau, January 2014. Web.