What Is an Adjustable-Rate Mortgage (ARM)?
Adjustable-rate mortgages (ARMs) are loans that feature a fixed interest rate for an introductory period, after which the interest rate is periodically reset. ARMs typically feature lower starting rates than other home loans, though they risk higher future rates than fixed-rate loans.
In an adjustable-rate mortgage the rate of interest can change over time. ARMs are also known as variable-rate mortgages or floating mortgages.
Understanding an Adjustable-Rate Mortgage (ARM)
An Adjustable-Rate Mortgage (ARM) has an initial fixed rate. The two numbers in most adjusted-rate mortgages indicate the length of time the fixed rate is applied to the loan, and the initial interest rate after that time elapses.
For example, a 3/25 ARM features a fixed rate for three years followed by a floating rate for the remaining 25 years.
Indexes vs. Margins
When the initial fixed-rate period ends, the interest rate on an adjustable-rate mortgage (ARM) can increase or decrease in line with a benchmark interest rate such as the prime rate, the rate on short-term U.S. Treasuries, or the Federal Funds rate.
Although the margin can change from time to time, the index rate stays the same. This is because as the index changes, the actual interest rate on your loan doesn’t – it’s always 1% higher than what you’d pay it didn’t have an adjustable-rate mortgage. For example, if the interest rate adjusts to 6% when 5% is expected, and the margin is 2%, the adjusted interest rate would be 8%.
However, if the index has only reached a level of 4% when it is expected to reach 5%, rates would adjust downward, with a margin of 2%, compounding to yield an adjusted interest rate of 4%.
ARM vs. Fixed Interest Mortgage
Fixed-rate mortgages have a fixed rate of interest for the life of the loan, while adjustable-rate mortgages have their interest rate change periodically. Due to this critical difference between a fixed-rate mortgage and an ARM, people often choose ARMs when low rates.
When you have a fixed interest mortgage, the interest rate remains fixed for the loan duration. Monthly payments remain constant throughout the life of the loan because interest charges are recalculated each month based on the remaining principal and a constant interest rate.
The advantage of a fixed-rate mortgage is that you won’t have to worry about refinancing; the rate you locked in at the beginning stays the same.
Is an Adjustable-Rate Mortgage Right for You?
Adjustable Rate Mortgages (ARMs) make financial sense if you plan to keep your loan for a short period and can afford the rate increases that come with an ARM.
With traditional fixed-rate mortgages, the rate is the same for the duration of the loan. However, with adjustable-rate mortgages (ARMs), the rate can change on a periodic or lifetime basis. The periodic cap sets the limits on the interest rate that can change from one year to another, while a lifetime cap limits how much the interest rate can go up over the life of the loan.
Adjustable Rate Mortgages (ARMs) offer lower rates than fixed-rate loans in exchange for uncertainty about your monthly mortgage payment for the life of the loan. A payment cap can limit how much the payment can increase.
If your lender is increasing your interest rate and you aren’t earning a higher income to cover it, negative amortization can make it challenging to keep up with your payments.
Adjustable-Rate Mortgages: The Pros and Cons
The pros of an adjustable-rate mortgage
1. Low payments in the fixed-rate phase
Adjustable-rate mortgages (ARMs) are a kind of mortgage loan that allows you to make lower monthly payments during the first few years with the knowledge that the interest rate can go up after the initial fixed period.
Compared to a fixed-rate loan, an ARM has a cheaper initial payment, but its interest rate can increase up to 20 percent without any cap.
The advantages of an adjustable-rate mortgage are that you can enjoy the lower initial rates for a fixed period and then sell before the rates go up.
3. Rate and payment caps
Buying an adjustable-rate mortgage, or ARM is a smart move if you are expecting higher interest rates in the future. A cap will protect you from unexpectedly high payments later on, which may result from higher interest rates in the future.
4. Your payments can decrease
If interest rates fall and drive down the index against the benchmarked ARM, there’s a possibility that your monthly payment gets reduced and you end up saving.
The cons of an adjustable-rate mortgage
1. Your payments could increase
If your payments are tied to interest rates, the payments may rise over time. Borrowers on a fixed income or working in troubled industries might have trouble making larger monthly mortgage payments.
2. Things don’t go as planned
ARM loans require borrowers to pay close attention to the interest rate and monthly payments. Since these rates can change, borrowers need to plan for this situation. Refinancing or selling at a future date may be difficult under certain circumstances, even with careful planning.
3. Prepayment penalty
One disadvantage you should know about adjustable-rate mortgages is that they have prepayment penalties. A prepayment penalty fee is charged if you sell or refinance the loan before a certain period.
If you plan to sell off your home within five years or refinancing your loan, your best option is to find a lender who offers loans without a prepayment penalty.
4. ARMs are complex
Adjustable-rate mortgages can have complicated rules. These complexities can prove risky for borrowers who don’t understand what they’re getting into.