What Is an Adjustable-Rate Mortgage (ARM)?
An adjustable-rate mortgage, commonly known as an ARM, is a home loan that offers an initial interest rate that is typically lower than that of a fixed-rate mortgage. However, this initial rate is not permanent. After a predetermined period, the interest rate on the ARM can adjust periodically, usually annually, based on a benchmark index plus a margin.
How Do ARMs Work?
ARMs are structured with an initial period where the interest rate is fixed. This period can range from a few months to several years, such as 1-year, 3-year, 5-year, 7-year, or 10-year ARMs. After this initial fixed period, the interest rate will adjust at set intervals.
The adjustment is based on a specific financial index, such as the Secured Overnight Financing Rate (SOFR), and a margin set by the lender. The margin is a fixed percentage added to the index to determine your new interest rate.
- Index: A benchmark interest rate that reflects general market conditions.
- Margin: A fixed percentage added to the index by the lender.
- Adjustment Period: The frequency at which the interest rate can change (e.g., annually).
- Rate Caps: Limits on how much the interest rate can increase at each adjustment period (periodic cap) and over the lifetime of the loan (lifetime cap). There’s also usually a cap on the initial adjustment.
Real-World Examples
Let’s say you get a 5/1 ARM. This means your interest rate is fixed for the first five years. After five years, your interest rate will adjust once per year based on the chosen index plus the lender’s margin.
If you have a 5/1 ARM with a 3% initial rate, and after five years the index plus margin equals 4.5%, your rate will increase to 4.5%. If the caps allow, your rate could increase further in subsequent years, or it could decrease if the index falls.
Who Affects ARMs?
ARMs can affect homebuyers who are looking for lower initial monthly payments, those who plan to sell or refinance their home before the adjustment period begins, or individuals who expect interest rates to decrease in the future.
- First-time homebuyers: May be attracted to lower initial payments.
- Short-term homeowners: Those who don’t plan to stay in the home for more than the initial fixed-rate period.
- Investors: May use ARMs for properties they plan to sell quickly.
- Borrowers with adjustable income: May benefit if their income is expected to rise.
Tips and Strategies for ARMs
- Understand the Caps: Always clarify the periodic and lifetime rate caps with your lender. This will help you estimate your maximum possible payment.
- Factor in Potential Increases: Budget for the possibility that your monthly payments could rise significantly after the fixed period.
- Monitor Market Rates: Keep an eye on the index your ARM is tied to and general interest rate trends.
- Consider Refinancing: If rates are falling or your financial situation changes, explore refinancing into a fixed-rate mortgage or a new ARM with better terms.
- Short-Term Strategy: If you plan to move or refinance before the first rate adjustment, an ARM can offer substantial savings.
Common Misconceptions about ARMs
- “ARMs are always riskier than fixed-rate mortgages.” While ARMs have payment uncertainty, they can be advantageous if managed correctly and if interest rates fall.
- “My payment will skyrocket immediately after the fixed period.” ARMs have caps that limit how much the rate can increase at each adjustment and over the loan’s lifetime.
- “All ARMs adjust at the same frequency.” The adjustment frequency depends on the type of ARM (e.g., 5/1, 7/1, 10/1).
Sources:
- Consumer Financial Protection Bureau (CFPB): What is an adjustable-rate mortgage? (https://www.consumerfinance.gov/ask-cfpb/what-is-an-adjustable-rate-mortgage-arm-en-1540/)
- Investopedia: Adjustable-Rate Mortgage (ARM) (https://www.investopedia.com/terms/a/arm.asp)