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How Mortgages Work
how mortgages work > Adjustable Rate Mortgages (ARM)

Adjustable-Rate Mortgages

Adjustable-rate mortgages, or ARMs, differ from fixed-rate mortgages in that the interest rate and monthly payment move up and down as the market fluctuates. Most have an initial fixed-rate period during which the borrower's rate doesn't change, followed by a much longer period during which the rate changes at preset intervals.

Adjustable Rates Start Low

Rates during the initial period of an ARM are generally lower than those on comparable fixed-rate mortgages. After all, lenders have to offer something to entice homebuyers to take on the risk of their payment rising in the future.

The initial fixed-rate period can be as short as a month or as long as 10 years. One-year ARMs, which had their first adjustment after one year, used to be the most popular adjustable, and were the benchmark. Recently the standard has become the 5/1 ARM, which has an initial fixed-rate period of five years; the rate adjusts at one-year intervals thereafter. That type of mortgage, which mixes a decent fixed period with a much longer adjustable period, is known as a hybrid. Other popular hybrid ARMs are the 3/1, the 7/1, and the 10/1.

With all ARMs, after the fixed-rate honeymoon, the interest rate fluctuates at the same rate as an index spelled out in closing documents. The lender finds out what the index value is, adds a margin to that figure, and recalculates the borrower's new rate and payment. The process repeats each time an adjustment date rolls around.

Most ARM rates are tied to the performance of one of three major indexes:

  1. The weekly constant maturity yield on the one-year Treasury Bill: The yield debt securities issued by the U.S. Treasury are paying, as tracked by the Federal Reserve Board.
  2. The 11th District Cost of Funds Index (COFI): The interest financial institutions in the western U.S. are paying on deposits they hold.
  3. The London Interbank Offered Rate (LIBOR): The rate most international banks are charging each other on large loans.

The Sky's Not the Limit

Luckily, borrowers have some protection from extreme changes because ARMs come with caps. These caps limit the amount by which ARM rates and payments can adjust. Caps come in a couple of different forms. The most common are:

  • Periodic rate cap: Limits how much the rate can change at any one time. These are usually annual caps, or caps that prevent the rate from rising more than a certain number of percentage points in any given year.
  • Lifetime cap: Limits how much the interest rate can rise over the life of the loan.
  • Payment cap: Offered on some ARMs, it limits the amount the monthly payment can rise over the life of the loan in dollars, rather than how much the rate can change in percentage points.

Interest-Only ARMs

Around the turn of the last century, lenders began to offer interest-only mortgages to middle-class borrowers. Formerly the preserve of those whom lenders considered affluent clients, interest-only mortgages are usually adjustables. For a specified period, usually 10 years, the borrower is only required to pay the interest. Then it adjusts to the going interest rate, as tracked by a specified index. After that, the loan amortizes at an accelerated rate.

During the interest-only period, the borrower can choose to pay some principal too. By providing flexibility in the size of monthly payments, interest-only mortgages are a good match for people with fluctuating monthly incomes, such as salespeople who are paid by commission.

Variety of Flavors for ARMs

Some ARMs come with a conversion feature that allows borrowers to convert their loans to fixed-rate mortgages for a fee. Others allow borrowers to make interest-only payments for a portion of their term, which keeps their payments low. But no matter the exact features, most ARMs are more difficult to understand than fixed-rate loans.

To keep your financial options open, make sure to ask the mortgage lender if the ARM is convertible to a fixed-rate mortgage. Also, ask if the ARM is assumable, which means when you sell your home the buyer may qualify to assume your existing mortgage. That could be desirable if you sell when mortgage interest rates are high.