The term adjustable rate mortgage (ARM) refers to a home loan with a variable interest rate. With an ARM, the initial interest rate is fixed for a period of time.
After that, the interest rate applied on the outstanding balance resets periodically, at yearly or even monthly intervals.
The interest rate for ARMs is reset based on benchmark or index, plus an additional spread called an ARM margin.
The London Interbank Offered Rate (LIBOR) was the typical index used in ARMs until October 2020, when it was replaced by the Secured Overnight Financing Rate (SOFR) in an effort to increase long-term liquidity.
ARMs are also variable-rate mortgages or floating mortgages. The interest rate for Adjustable Rate Mortgages (ARMs) is typically reset based on specific financial indexes or reference rates. These indexes are external indicators of the overall market conditions and can fluctuate over time.
The most common indexes used for ARMs include:
- London Interbank Offered Rate (LIBOR): LIBOR is an average interest rate that major international banks charge each other for short-term loans. However, please note that LIBOR is expected to be phased out by the end of 2021, and many financial institutions are transitioning to alternative reference rates.
- U.S. Constant Maturity Treasury (CMT): CMT represents the average yield on U.S. Treasury securities with different maturities. Common CMT indexes used for ARMs include the 1-year CMT, 3-year CMT, 5-year CMT, etc.
- Cost of Funds Index (COFI): COFI is an index that reflects the interest expenses incurred by savings institutions in the western United States. It is based on the interest rates paid on savings accounts and certificates of deposit.
- Prime Rate: The Prime Rate is the interest rate that commercial banks charge their most creditworthy customers. It is often used as an index for certain types of ARMs, although it is less common compared to the previously mentioned indexes.
The specific terms of an ARM will outline the index it uses, as well as additional factors such as the margin, adjustment frequency, and caps, which determine how much the interest rate can change at each reset period.
What you must know about Adjustable Rates Mortgages (ARMs)
- An adjustable-rate mortgage is a home loan with an interest rate that can fluctuate periodically based on the performance of a specific benchmark.
- ARMS are also called variable rate or floating mortgages.
- ARMs generally have caps that limit how much the interest rate and/or payments can rise per year or over the lifetime of the loan.1
- An ARM can be a smart financial choice for homebuyers who are planning to keep the loan for a limited period of time and can afford any potential increases in their interest rate.
Understanding Adjustable Rate Mortgages (ARMs)
Mortgages allow homeowners to finance the purchase of a home or other piece of property. When you get a mortgage, you will have to repay the borrowed sum over a set number of years. Similarly too, you will pay the lender something extra to compensate them for their troubles like possibly inflation. It is possible the value of the balance by the time the funds are reimbursed.
In most cases, you can choose the type of mortgage loan that best suits your needs. A fixed-rate mortgage comes with a fixed interest rate for the entirety of the loan. As such, your payments remain the same.
An ARM, where the rate fluctuates based on market conditions. This means that you benefit from falling rates and also run the risk if rates increase.
Different periods to an ARM
There are two different periods to an ARM. One is the fixed period, and the other is the adjusted period. Here’s how the two differ:
- Fixed Period: The interest rate doesn’t change during this period. It can range anywhere between the first five, seven, or ten years of the loan. This is commonly known as the intro or teaser rate.
- Adjusted Period: This is the point at which the rate changes. Changes made during this period is dependent on the underlying benchmark, which fluctuates based on market conditions.
Key Characteristic of Adjustable Rate Mortgage
Another key characteristic of Adjustable Rate Mortgage is whether they are conforming or nonconforming loans. Conforming loans are those that meet the standards of government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac.
They are packaged and sold off on the secondary market to investors. Nonconforming loans, on the other hand, aren’t up to the standards of these entities and aren’t sold as investments.
Rates are capped on ARMs. This means that there are limits on the highest possible rate a borrower must pay. Keep in mind, though, that your credit score plays an important role in determining how much you’ll pay. So, the better your score, the lower your rate.
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Types of ARMs (Adjustable Rates Mortgage)
ARMs generally come in three forms: Hybrid, interest-only (IO), and payment option. Here’s a quick breakdown of each.
1. Hybrid Adjustable Rates Mortgage
Hybrid ARMs offer a mix of a fixed- and adjustable-rate period. With this type of loan, the interest rate will be fixed at the beginning and then begin to float at a predetermined time.
This information is typically expressed in two numbers. In most cases, the first number indicates the length of time that the fixed rate is applied to the loan, while the second refers to the duration or adjustment frequency of the variable rate.
For example, a 2/28 ARM features a fixed rate for two years followed by a floating rate for the remaining 28 years. In comparison, a 5/1 ARM has a fixed rate for the first five years, followed by a variable rate that adjusts every year (as indicated by the number one after the slash). Likewise, a 5/5 ARM would start with a fixed rate for five years and then adjust every five years.2
You can compare different types of ARMs using a mortgage calculator.
2. Interest-Only (I-O) ARM
It’s also possible to secure an interest-only (I-O) ARM, which essentially would mean only paying interest on the mortgage for a specific time frame, typically three to 10 years. Once this time expires, you will have to pay both interest and the principal on the loan.
These types of plans appeal to those keen to spend less on their mortgage in the first few years so that they can free up funds for something else, such as purchasing furniture for their new home.
3. Payment-Option ARM
A payment-option ARM is, as the name implies, an ARM with several payment options. These options typically include payments covering principal and interest, paying down just the interest, or paying a minimum amount that does not even cover the interest.4
Opting to pay the minimum amount or just the interest might sound appealing. However, remember that you will pay the lender back everything on the specific date in the contract and that interest charges are higher when the principal is not paid off.
If you persist with paying off little, then you’ll find your debt keeps growing, perhaps to unmanageable levels.
Advantages and Disadvantages of Adjustable Rate Mortgage – ARM
Adjustable-rate mortgages come with many benefits and drawbacks. We’ve listed some of the most common ones below.
Advantages of ARM – Adjustable Rate Mortgage
The most obvious advantage is that a low rate, especially the intro or teaser rate, will save you money. Not only will your monthly payment be lower than most traditional fixed-rate mortgages, but you may also be able to put more down toward your principal balance. Just ensure your lender doesn’t charge you a prepayment fee if you do.
ARMs are great for people who want to finance a short-term purchase, such as a starter home. Or you may want to borrow using an ARM to finance the purchase of a home that you intend to flip. This allows you to pay lower monthly payments until you decide to sell again.
More money in your pocket with an ARM also means you have more in your pocket to put toward savings or other goals, such as a vacation or a new car.
Unlike fixed-rate borrowers, you won’t have to make a trip to the bank or your lender to refinance when interest rates drop. That is because you probably are already getting the best deal available.
Disadvantages of ARM – Adjustable Rates Mortgage
One of the major cons of ARMs is that the interest rate will change. This means that if market conditions lead to a rate hike, you may likely spend more on your monthly mortgage payment. And that can put a make you have a bad record.
ARMs may offer you flexibility, but they don’t provide you with any predictability as fixed-rate loans do. Borrowers with fixed-rate loans know what their payments will be throughout the life of the loan because the interest rate never changes. But because the rate changes with ARMs, you’ll have to keep juggling your budget with every rate change.
Borrowers have many options available to them when they want to finance the purchase of their home or another type of property. You can choose between a fixed-rate or an adjustable-rate mortgage.
While the former provides you with some predictability, ARMs offer lower interest rates for a certain period of time before they begin to fluctuate with market conditions.