Adjustable Rate Mortgages (ARM)

In general, adjustable-rate mortgages can offer lower interest rates and mortgage payments at first because the borrower assumes the risk of changes in interest rates. Usually borrowers choose ARMs because the lower initial payment makes the home more affordable at first, but the borrower must be willing to accept the risk of an increased mortgage payment, which can sometimes be significantly higher.

After a specified period of time, the interest rate and payments on an ARM are adjusted based on changes to a specific interest rate index (such as the U.S. treasury bill rate). These adjustments occur at times specified in the ARM disclosure you receive from the lender and can result in payment increases. There is always a floor cap, payment cap, and life cap on the rate. It’s important to understand all the aspects of ARMs before you make your decision.

Understanding an Adjustable-Rate Mortgage (ARM)

Typically an ARM is expressed as two numbers. In most cases, the first number indicates the length of time the fixed-rate is applied to the loan.

For example, a 2/28 ARM features a fixed rate for two years followed by a floating rate for the remaining 28 years. In contrast, a 5/1 ARM boasts a fixed rate for five years, followed by a variable rate that adjusts every year (as indicated by the number one). Similarly, a 5/5 ARM starts with a fixed rate for five years and then adjusts every five years.

Indexes vs. Margins

At the close of the fixed-rate period, ARM interest rates increase or decrease based on an index plus a set margin. In most cases, mortgages are tied to one of three indexes: the maturity yield on one-year Treasury bills, the 11th District cost of funds index, or the London Interbank Offered Rate.

Although the index rate can change, the margin stays the same. For example, if the index is 5% and the margin is 2%, the interest rate on the mortgage adjusts to 7%. However, if the index is at only 2% the next time the interest rate adjusts, the rate falls to 4%, based on the loan's 2% margin.

Special Considerations

An ARM can be a smart financial choice for home buyers that are planning to pay off the loan in full within a specific amount of time or those who will not be financially hurt when the rate adjusts. In many cases, ARMs come with rate caps that limit how high the rate can be and/or how drastically the payments can change.

Periodic rate caps limit how much the interest rate can change every year to the next, while lifetime rate caps set limits on how much the interest can increase over the life of the loan. Finally, there are payment caps that stipulate how much the monthly mortgage payment can increase. Payment caps detail increases in dollars rather than based on percentage points.