Defining Adjustable-Rate Mortgages (ARMs)
An adjustable-rate mortgage (ARM) refers to any mortgage loan where the interest rate changes over the loan’s lifetime. This type of mortgage loan is also called a variable-rate mortgage and a floating mortgage.
The terms of the variable interest rate are set at the beginning of the mortgage. At that time, the frequency of variation is established along with the loan period. The frequency of variation is distinct from a fixed-rate mortgage, which has a set mortgage interest rate that does not change over the loan’s lifetime.
Adjustable-Rate Mortgage Characteristics
Two numbers are used to describe adjustable-rate mortgages. The first number represents the number of years that the mortgage rate will stay fixed at the beginning of the loan. The second number usually represents the frequency of changes in interest rates.
ARMs can vary at any interval, but the interval is always established while the borrower is negotiating the terms of the loan. Whereas a typical fixed-rate mortgage has a set term with the same interest rate, ARMs can have the same loan period with built-in variations.
For example, a mortgage described as a 5/25 adjustable-rate mortgage is characterized by five years of the initial mortgage rate and 25 years of floating interest rates. If the second number is a one, such as a 5/1 ARM, that indicates that the interest rate will change annually after the first five years.
The time between mortgage rate changes with an ARM is called the adjustment period. A loan may be described as a 1-year ARM if it has an adjustment period of one year.
Adjustable-rate mortgages can be taken out for any period of time, dependent on the lender and borrower. However, these loans are commonly taken out for shorter periods of time, such as 15 years or less.
How Rate Changes Are Calculated
With a variable mortgage rate, borrowers can expect to see changes in their loan interest rate at the start of any adjustment period. Interest rate adjustments are not arbitrary. Instead, they are based on a few specific factors, notably indexes and margins. Certain interest rate caps are also applied to most consumer ARMs.
Most adjustable-rate mortgages are tied to a specific interest rate index. The common indexes are maturity yield on 1-year U.S. Treasury bills, the 11th District cost of funds index, and the London Interbank Offered Rate.
Depending on whether these indexes have gone up or down and how much, the mortgage interest rate will likely follow the same trend. Most ARMs are tied to one specific index. Prospective borrowers should always understand which index the mortgage rate is tied to and research the particular index’s historical trends.
The margin of an ARM is the percentage of profit for the lender on top of the interest rate. Margins are usually expressed in percentages and will sit on top of any index changes.
For example, if the index that an ARM is tied to is at 3.5% with a 2% margin, the ARM interest rate will be 5.5% during the adjustment period.
Mortgage interest rate caps are usually put in place to protect borrowers from predatory mortgage rate hikes during a particular adjustment period. A rate cap can be done in one of two ways:
- Lifetime Rate Cap: A lifetime rate cap is an interest rate cap that prevents the mortgage interest rate from going above a certain percent. Most ARMs in the U.S. are legally required to have a lifetime cap, even if they also have a periodic rate cap.
- Periodic Rate Cap: These caps apply only to increases in the interest rate during each adjustment period. A periodic rate cap prevents the mortgage interest rate from increasing or decreasing by more than a certain percentage each time.
The combination of interest rate caps, index values, and margins is how mortgage lenders calculate the changes to a specific ARM each adjustment period. Changes will be unique to the loan, depending on the terms the borrower agrees to during the application process.
Adjustable-Rate Mortgage Considerations for Homebuyers
Adjustable-rate mortgages tend to be riskier than fixed-rate mortgages. It is difficult to predict what will happen with the index values during the lifetime of the loan. Although ARMs often have lower rates upfront, they may have much higher rates as each adjustment period passes.
Buyers who plan to pay off their mortgage quickly may be better off with an adjustable-rate mortgage because it will allow them to pay lower interest rates over the loan’s short period. However, buyers looking for a long-term loan might be better served by a stable fixed-rate mortgage.
Marimark Mortgage is based in Tampa, Florida, and serves the mortgage needs of homebuyers, homeowners, and investors in Florida, Virginia, and Pennsylvania.
We specialize in adjustable-rate mortgages, conventional home mortgages, FHA, VA, and USDA mortgage options, refinance loans, and reverse mortgages. We have worked extensively with cash-out refinancing and help clients to lower their monthly mortgage payments.