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Adjustable-Rate Mortgage (ARM)

What It Is & the Pros and Cons

What Is an ARM?

An adjustable-rate mortgage, or ARM, has an introductory interest rate that lasts a set period of time. When that period ends, the interest rate applied on the outstanding balance adjusts periodically, throughout the duration of the loan, and so will your monthly payment. Some might say that initial rate is a teaser rate or a low rate that is offered as an incentive to choose a certain mortgage program. The concept is somewhat similar to offers you see for 0% APR credit cards. ARMs are also called variable-rate mortgages or floating mortgages. As interest rates rise, they gain in popularity

 

The interest rate for ARMs is reset based on a benchmark or index, plus an additional spread called an ARM margin. (Ask your lender for a detailed explanation.) The rate may move both up or down depending on the direction of the index it is associated with, the state of the economy and the general cost of borrowing. An ARM can be a smart financial choice for homebuyers who are planning to keep the loan for a limited period of time and/or can afford any potential increases in their interest rate.

Types of ARMs

ARMs are usually available in three forms: Hybrid, interest-only (IO), and payment option:

  • 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 rateis applied to the loan, while the second refers to the adjustment frequency of the variable rate.
  • An interest-only (I-O) ARM, means only paying interest on the mortgage for a specific time frame—typically three to 10 years. Once this period expires, you are then required to pay both interest and the principalon the loan. The longer the I-O period, the higher your payments will be when it ends.
  • A payment-option ARMis 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 doesn’t cover the interest. You will have to pay the lender back everything by the date specified in the contract, and interest charges are higher when the principal isn’t getting paid off. Your debt keeps growing.

 

What Are ARM Caps?

ARM caps limit interest rate movement throughout the life of the loan. There are three different caps that limit how much your interest rate can change

  • The initial capis the amount the interest rate can fluctuate in the very first adjustment.
  • The periodic capis the maximum amount each interest rate adjustment can be after the initial rate change.
  • The lifetime capis the maximum amount the interest rate can change over the entire the loan period.

 

While caps are intended to keep payments from spiraling out of control, they still allow for big payment swings. The caps allow the interest rate to go both up and down. So, if the market is improving, your adjustable-rate mortgage can go down, but your rate will never swing higher or lower more than the caps allow. Some lenders put in interest rate floors that often coincide with the initial rate, meaning your rate will never go below its start rate.

 

What to Consider before You Choose an ARM

  • The main draw of an ARM is the lower interest rate compared to what’s available on a fixed-rate mortgage (FRM).
  • A lower initial interest rate can save you money each month and decrease your monthly payments for a set period, but it’s not without risk if interest rates rise significantly.
  • Timing also plays a role because spreads between ARMs and FRMs may widen or contract based on market conditions and other economic issues. If fixed rates are high, an ARM seems more attractive.
  • The longer the initial fixed-rate period on the ARM, the lower the interest rate discount. This can be a good deal for a homeowner who only needs short-term financing.
  • If the home you’re buying is a short-term investment, or if you don’t plan on owning the home for more than five years, the savings realized during the fixed-rate period could eclipse any subsequent payment increases.
  • Most homeowners who choose an ARM for the lower initial payment usually refinance the loan when the fixed period ends.

 

Adjustable-Rate Mortgage (ARM) vs. Fixed-Rate Mortgage (FRM)

Unlike ARMs, traditional or FRMs carry the same interest rate for the life of the loan, which might be 10, 20, 30, or more years. They generally have higher interest rates at the outset than ARMs, which can make ARMs more attractive and affordable in the short term. However, FRMs eliminate the risk that the borrower’s rate will shoot up to a point where loan payments may become unmanageable.

 

With a fixed-rate mortgage, monthly payments remain the same, although the amounts that go to pay interest or principal will change over time, according to the loan’s amortization schedule. If interest rates in general fall, then homeowners with fixed-rate mortgages can refinance, paying off their old loan with one at a new, lower rate.

 

Is an Adjustable-Rate Mortgage Right for You?

ARMs aren’t for everyone. The favorable introductory rates are appealing, and an ARM could help you to get a larger loan for a home. However, it’s hard to budget when monthly payments can fluctuate widely. You could end up in financial trouble if interest rates spike, especially if there are no caps in place. You’re taking a risk with an ARM as opposed to an FRM that never changes. Decide what you want to do with the home over the next five years, talk with your lender about an interest plan, and then you’ll be able to more wisely decide if an adjustable-rate mortgage is right for you.

 

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