An Adjustable-Rate Mortgage (ARM) is a type of mortgage with an interest rate that changes (adjusts) throughout the life of the loan – after a fixed rate period. You lock in a low mortgage rate for 5, 7, or 10 years, then the interest rate changes periodically thereafter, based on the market at the time. With a conventional ARM, the rate changes every 6 months. ARMs typically offer the lowest possible mortgage rate, compared to a 30-year fixed loan term, which can mean a lower monthly mortgage payment!
Understanding Adjustable-Rate Mortgages (ARMs)
With lower rates and flexible loan terms, ARMs are beneficial to a variety of home buyers – affording borrowers with home buying opportunities they didn’t know they had!
- Lower monthly payment upfront
- Lower initial interest rate
- Qualify for a higher loan amount
Who is a good fit for an ARM?
With lower rates and flexible loan terms, this an ideal loan type for a variety of homebuyers, including:
- College graduates needing to pay off debt
- Growing families
- Someone who plans to relocate
- A homeowner living in a temporary home
- Borrower looking to refinance before the rate changes
- A home buyer looking to buy when interest rates are high
How Does an Adjustable-Rate Mortgage Work?
It’s important to understand different ARM options, which are represented by numbers based on the loan terms. The first number is the length of the fixed-rate period while the second number is the frequency at which the interest rate changes following the fixed-rate period.
Different Types of ARMs:
5/1 - Fixed rate for 5 years, annual rate adjustment for the life of the loan thereafter
10/1 - Fixed rate for 10 years, annual rate adjustment for the life of the loan thereafter
5/6 - Fixed rate for 5 years, rate adjustment every 6 months for the life of the loan thereafter
7/6 - Fixed rate for 7 years, rate adjustment every 6 months for the life of the loan thereafter
10/6 - Fixed rate for 10 years, rate adjustment every 6 months for the life of the loan thereafter
Fixed-Rate Vs. Adjustable-Rate Mortgage: What’s the Difference?
A fixed-rate mortgage simply means that you have the same (fixed) interest rate for the life of the loan – it never changes. Your mortgage payment will be the same amount every month.
An adjustable-rate mortgage has a fixed rate for a set time, then is adjusted throughout the remainder of the loan. In the adjustable-rate period, because the interest rate changes, your loan amount may vary (every 6 months or annually) depending on the ARM option.
During the agreed upon interest-only period, the borrower is only required to pay interest and not any principal owed. The length of the interest-only period can vary from a few months to several years.
Conforming vs Non-Conforming ARMs
Conforming loans are mortgages that meet specific guidelines that allow them to be sold to Fannie and Freddie Mac.
If a loan doesn’t meet these specific guidelines, then it will fall into the nonconforming category. A non-conforming ARM might be right for you if you don’t qualify for either a government-backed loan or conforming conventional loan.
An ARM with several payment options. These include payments covering principal and interest, paying down just the interest, or paying a minimum amount that does not fully cover the interest.
How are ARM Rates Determined?
To calculate the mortgage rate on an adjustable (ARM) loan, you combine the index and the margin. The resulting number is known as the “fully indexed rate.” This rate gets applied to your monthly payments.
When is an Adjustable-Rate Mortgage a Bad Idea?
If you are planning to stay in the house for the long-term, interest rates could begin to rise, and your payment could increase after the adjustable period begins.
If you want a predictable mortgage payment or can’t afford a higher mortgage payment than an ARM is likely not for you.
Can I Convert from an ARM to a Fixed-Rate Mortgage?
Switching from an adjustable-rate mortgage (or ARM) to a fixed-rate mortgage is one of the most common reasons to refinance. Refinancing to a fixed-rate loan usually makes the most sense when interest rates are low.
What are Rate Caps for ARMs?
An annual ARM cap is a clause in the contract of an ARM that limits the possible increase in the loan's interest rate during each year. The cap, or limit, is usually defined in terms of rate, but the dollar amount of the principal and interest payment may also be capped.