Key Takeaways
- ARMs often start with lower rates, saving money initially.
- Interest rates can change, impacting your monthly payment.
- Rate caps limit how much your rate can increase annually.
- Ideal for short-term ownership or when interest rates are high.
Article Summary
An adjustable-rate mortgage (ARM) is a home loan whose interest rate can change over time.
Adjustable-Rate Mortgage: Explained in Plain English
An adjustable-rate mortgage (ARM) is a mortgage where the interest rate remains fixed for a certain number of years - usually 5 or 7 - and then changes annually or semi-annually for the loan's remaining loan term.
Adjustable interest rates are an optional mortgage feature and strictly regulated to protects homeowners and lenders from rising rates and PITI, which can spark mortgage default and foreclosure.
Historically, approximately 10 percent of home buyers choose an adjustable-rate option.
ARMs are available for conventional mortgages, FHA mortgages, and VA mortgages, but not USDA mortgages; and ARMs can be used to finance all types of residential homes, including houses, condos, multi-units, and manufactured homes.
What Makes Up An Adjustable-Rate Mortgage
| Element | What It Means |
|---|---|
| Start Rate | Fixed for first 3, 5, 7, or 10 years |
| Adjustment | Rate changes after the fixed period |
| Index | The market rate used for adjustments |
| Margin | Added to the index for your new rate |
| Caps | Limits how much your rate may change |
| Payment | May go up or down after each adjustment |
How Adjustable-Rate Mortgages Work
An adjustable-rate mortgage is based on a standard fixed-rate mortgage contract. Its only difference is how its mortgage rate behaves.
With an ARM, the home buyer selects how many years until the loan's first interest rate adjustment. Five years is the most common selection, which creates a 5-year ARM.
Home buyers can also choose 3-year ARMs, 7-year ARMs, and 10-year ARMs.
Next, the lender assigns an interest rate. Then, the loan is given a margin and an index.
The margin is a constant used to find future interest rate adjustments. The index is the variable by which the adjustable rate adjusts.
When an ARM adjusts, its new interest rate is the sum of the margin plus the index, so long as the sum falls within given limits.
ARM limits are known as caps.
Caps hold ARM interest rates within a safe, controlled range. A typical cap prevents rates from moving up or down by more than 2 percentage points.
Caps on a 5-year ARM look like this:
- After five years, the adjustment is capped at ±5 percentage points
- Every year after, the adjustment is capped at ±2 percentage points
Non-conforming ARMs, including jumbo and portfolio loans, may use different indexes, margins, and caps.
Types of Adjustable-Rate Mortgages
The majority of adjustable-rate mortgages are issued via Fannie Mae or Freddie Mac. Other ARM types also exist. Let's review them all.
The Hybrid ARM
Hybrid mortgage ARMs are another name for conventional mortgage ARMs. It's name "hybrid" refers to the loan's adjustment schedule, which causes it to resemble a fixed-rate mortgage for a few years and then an adjustable-rate mortgage later.
The standard Hybrid ARM margin is 2.75 percent, and its index is often set to the 1-year Constant Maturity Treasury. Conventional ARMs are structured as 5-Year ARMs most commonly.
The FHA ARM
FHA ARMs are a variation of the standard FHA mortgage. FHA ARMs adjust after every year in their 30-year loan term, with a mandated interest cap of 1 percentage point per year and five percentage points over the life of the loan.
The VA ARM
The VA ARM is similar to the FHA ARM. It's a variation of the standard VA mortgage. VA ARMs adjust once annually throughout their 30-year loan term and carry a VA-mandated interest cap of 1 percentage point per year and five percentage points over the life of the loan.
The Interest-Only ARM
Interest-only ARMs are adjustable-rate loans whose standard payment does not include a principal balance component. Government regulation reduced the availability of interest-only loans between 2008-2012.
Today, Interest Only ARMs are only available from local banks as specialty products.
Payment Option ARM
Payment option ARMs were retired in 2008 for poor performance. Sometimes called Option ARMs, they were adjustable-rate loans that let homeowners choose from four payment options - full payment, partial payment, interest-only payment, and minimum payment.
When To Use An Adjustable-Rate Mortgage
Selling or Refinancing Within Five Years
If you know you will sell your home within five years or plan to refinance, a 5-year ARM may help you get a lower mortgage rate and save money on your loan. This works well for buyers who do not plan to keep the same mortgage long-term.
Comfortable Sharing Interest Rate Risk
Adjustable-rate mortgages usually start with a lower interest rate than fixed-rate loans. After the initial period, the rate adjusts. If you are comfortable with the possibility of your mortgage rate changing, an ARM may be a good fit.
If Adjustable Rates Make You Worry
If the idea of a changing mortgage rate makes you uneasy, a fixed-rate mortgage may be a better choice. Peace of mind is important, and no savings are worth losing sleep over your loan.
Adjustable-Rate Mortgage Availability by Loan Type
| Loan Type | Adjustable-Rate Option Available? |
|---|---|
| Conventional | Yes |
| FHA | Yes |
| VA | Yes |
| USDA | No |
| Jumbo | Yes |
| Non-QM | Yes |
Adjustable-Rate Mortgage: A Real World Example
Say a buyer takes out a 5/1 ARM for $300,000 at an initial rate of 5%. For the first five years, the monthly P+I payment is around $1,600. That figure doesn't change during the initial 5-year period.
When the 5 years are over, the buyer's loan adjusts once per year. If the economy is going strong, the adjusted rate could be higher, the new monthly payment could be $1,800 or something else. If the economy continue to expand, the P+I payments could go up again the following year.
But the reverse can also happen. If the economy contracts, the formula used to make the adjusted rate can adjust downward.
The trade-off with ARMs is: lower starting payments in exchange for future payment uncertainty.
Commons Questions About Adjustable-Rate Mortgages
Get answers to frequently asked questions about adjustable-rate mortgages, safety, and refinancing options.
What is a "Toxic ARM?"
Between 2005-2008, some mortgage lenders sold ARMs known as Payment Option ARMs. Payment Option ARMs let homeowners choose from monthly payment options for the first five years. Many homeowners chose the least costly option, adding additional principal to the home's existing loan balance. When home values started to drop, a clause in the Option ARM paperwork triggered a reset. Homeowners' new payments spiked, and large numbers of homes went into foreclosure. For the damage they did to the mortgage ecosystem, Payment Option ARMs are now known as Toxic ARMs.
Are ARMs safe?
Adjustable-rate mortgages are safe when used responsibly. Starting interest rates are lower than fixed-rate mortgages, and interest rate caps prevent rapidly rising payments.
Are ARMs better than fixed-rate mortgages?
ARMs are neither better nor worse than fixed-rate mortgages. ARMs may be right for you if you plan to sell or refinance within five years of purchase or if you are comfortable sharing the time risk of your loan.
Are fixed-rate mortgages safer than ARMs?
Fixed-rate mortgages are not safer than ARMs. The benefit of a fixed-rate mortgage is that you know what your exact mortgage payment will be for the next 30 years. In exchange for that certainty, you'll pay a higher mortgage rate. Fixed-rate mortgages aren't more safe - they're more certain.
Can my ARM interest rate jump to 20% overnight?
No, because of caps, your ARM can't change overnight or go to 20 percent. ARMs can only adjust after the initial starting period ends and on subsequent anniversaries. And, when ARMs adjust, they can only change by a few percentage points at a time.
Can you refinance an adjustable-rate mortgage?
Homeowners can refinance an ARM or fixed-rate mortgage at any time. However, ARMs don't constantly adjust higher. Before refinancing your ARM, compare your upcoming adjusted interest rate to today's mortgage rates. If today's rates are higher, you may want to avoid refinancing your ARM.
