An adjustable-rate mortgage (ARM) refers to a mortgage loan with an interest rate that changes over the life of the loan. It may also be called a variable-rate mortgage or a floating mortgage.
The variable interest rate terms are set at the beginning of the mortgage. At that time, the variation frequency is established along with the loan period. This is distinct from a fixed-rate mortgage, which has a set mortgage interest rate that will not change over the life of the loan.
Adjustable-Rate Mortgage Characteristics
There are two numbers used to describe adjustable-rate mortgages. The first number represents the number of years the mortgage rate remains fixed. The second number usually represents the frequency of changes in the interest rate.
ARMs can vary at different intervals; however, the interval is permanently established before the mortgage closes.
For example:
- A 5/25 ARM is a 30-year mortgage with the first five years fixed and the remaining 25 years adjustable.
- A 5/1 ARM is a mortgage with a fixed rate for the first five years, then switches to an adjustable-rate mortgage for the remainder of its term. The interest rate can be adjusted up or down annually, depending on several factors.
The adjustment period is the time between mortgage rate changes with an ARM. For example, a mortgage loan is described as a 1-year ARM if it has an adjustment period of one year.
Adjustable-rate mortgages can be taken out for various periods. However, they are commonly taken out for shorter periods, such as 15 years or less, rather than 25-30 years.
Related: How ARM Rates Work: 3/1, 5/1, 7/1, and 10/1 Mortgages
How Rate Changes Are Calculated
With a variable mortgage rate, borrowers can expect to see changes in their loan’s interest rate at the start of the 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.
Indexes
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.
- 11th District cost of funds index.
- London Interbank Offered Rate.
Generally, the interest rate for an ARM moves up and down as the index to which it is tied moves up and down. Therefore, choosing an ARM tied to an index less likely to increase can result in a lower interest rate over the loan term.
Margins
The margin of an ARM is the percentage the lender charges over the index interest rate. If a loan has a 2% margin, 2% is added to the index price to calculate the mortgage interest rate.
So, for example, if the index that the loan is tied to is at 1.5% and there is a 2% margin, the borrower’s interest rate will be 3.5%.
Rate Caps
Mortgage interest rate caps are usually implemented to protect borrowers from excessive mortgage rate increases during a particular adjustment period. A rate cap can be done in one of two ways:
- Lifetime Rate Cap: This is an interest rate cap that prevents the mortgage interest rate from going above a certain percentage over the life of the loan. 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: This applies 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.
Changes in the interest rate of an ARM are calculated by applying the interest rate caps, changes in the index value, and the margin.
Considerations for Home Buyers
Adjustable-rate mortgages tend to be riskier than fixed-rate mortgages because it is difficult to predict the change in interest rates during the life of the loan. Although ARMs often have lower rates initially, they may have higher rates later if interest rates rise.
ARMs are generally better for homebuyers who plan to pay off their mortgage quickly since a shorter-term mortgage has less risk of being affected by rising interest rates. Likewise, buyers looking for a long-term mortgage loan are often better served with a fixed-rate mortgage.
Marimark Mortgage
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