What Is an Adjustable-Rate Mortgage (ARM)?

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A home loan with a variable interest rate is an adjustable-rate mortgage (ARM). The initial interest rate on an ARM is fixed for a period of time. After that, the interest rate on the outstanding balance is reset periodically, either annually or monthly.
Adjustable-Rate Mortgage (ARM)

ARMs are also referred as variable-rate or floating mortgages. The interest rate on ARMs is recalculated based on a benchmark or index, plus a spread known as an ARM margin. The London Interbank Offered Rate has been the standard index for adjustable-rate mortgages (LIBOR).

• An adjustable-rate mortgage (ARM) is a home loan with an interest rate that fluctuates periodically based on the performance of a specific benchmark.

• ARMs generally have caps that limit how much the interest rate and/or payments could indeed rise per year or over the life of the loan.

Understanding an Adjustable-Rate Mortgage (ARM)

When you obtain a mortgage, you will be required to repay the borrowed amount over a specified number of years, as well as compensate the lender for their trouble and the possibility that inflation will erode the value of the balance by the time the funds are repaid.

In most cases, you will have the option of keeping this interest rate fixed for the duration of the loan or allowing it to fluctuate. Generally, the initial borrowing costs of an ARM are fixed at a rate that is lower than what you would receive with a comparable fixed-rate mortgage. However, after that point, the interest rate that affects your monthly payments may increase or decrease based on the economic climate and the overall cost of borrowing.

Different Types of ARMs

There are typically three types of adjustable-rate mortgages: hybrid, interest-only (IO), and payment option. Here is a brief summary of each type.

Hybrid ARM

Hybrid ARMs combine a fixed- and variable-rate period. This type of loan will initially have a fixed interest rate, which will then begin to fluctuate at a predetermined time.

Typically, this information is expressed as two numbers. In the majority of instances, the first number represents the length of time that the fixed rate is applied to the loan, while the second number refers to the duration  time or adjustment frequency of the variable rate.

A 2/28 ARM, for instance, has a fixed rate for two years followed by a variable rate for the remaining 28 years. In contrast, a 5/1 ARM has a fixed rate for the first five years, followed by an annually adjusting variable rate (as indicated by the number one after the slash). Similarly, a 5/5 ARM would begin with a fixed rate for five years before adjusting annually.

A mortgage calculator can be used to compare different types of adjustable-rate mortgages.

Interest-only (I-O) adjustable-rate mortgage

It is also possible to obtain an interest-only adjustable-rate mortgage (I-O ARM), which entails paying only the interest on the mortgage for a specified period of time, typically three to ten years. After this period expires, you will be responsible for paying both interest and the loan's principal.

These types of plans appeal to those who wish to spend less on their mortgage in the first few years in order to free up funds for something else, such as the purchase of new furniture. Obviously, this advantage comes with a price: The longer the I-O period, the greater your final payments will be.

Payment-option ARM

As the name suggests, a payment-option ARM is an ARM with multiple payment options. These options typically include principal and interest payments, interest-only payments, or minimum payments that do not even cover the interest.

The option to pay only the interest or the minimum amount may sound alluring. However, it is important to remember that you must repay the lender in full by the contract's due date, and that interest rates are higher when the principal is not repaid. If you continue to make minimal payments, your debt will continue to grow, possibly to unmanageable levels.

How the Variable Rate Is Determined for ARMs

At the conclusion of the initial fixed-rate period, ARM interest rates become variable (adjustable) and fluctuate based on a reference interest rate (the ARM index) plus a predetermined amount of interest above the index rate (the ARM margin). The index for adjustable-rate mortgages is typically a benchmark rate, such as the LIBOR, the prime rate, the Secured Overnight Financing Rate (SOFR), and the rate on short-term U.S. Treasuries.

Although the index rate is subject to change, the margin remains constant. For instance, if the index is 5% and the margin is 2%, the mortgage interest rate will adjust to 7%. However, if the index is only 2% when the next interest rate adjustment occurs, the rate falls to 4% based on the loan's 2% margin.

The interest rate on adjustable-rate mortgages (ARMs) is determined by a fluctuating benchmark rate that typically reflects the economic climate and a fixed margin charged by the lender.

Adjustable-Rate Mortgage vs. Fixed Interest Mortgage

In contrast to adjustable-rate mortgages, traditional or fixed-rate mortgages carry the same interest rate for the duration of the loan, which may be 10, 20, 30, or more years. They typically have higher initial interest rates than ARMs, which can make ARMs more affordable and attractive in the short term. However, fixed-rate loans provide the assurance that the borrower's interest rate will never increase to an unmanageable level.

With a fixed-rate mortgage, the monthly payment remains constant, but the proportion of the payment that goes toward interest and principal varies according to the loan's amortization schedule.

If interest rates decline in general, homeowners with fixed-rate mortgages can refinance by replacing their old loan with a new one at a lower rate.

Lenders are required to put all terms and conditions of the ARM in which you are interested in writing. This includes information about the index and margin, how your rate will be calculated and how frequently it can be changed, whether there are caps in place, the maximum amount that you may be required to pay, and other pertinent factors, such as negative amortization.

Is an Adjustable-Rate Mortgage Right for You?

An adjustable-rate mortgage (ARM) may be a prudent financial choice if you plan to keep the loan for a limited time and can afford rate increases during that time.

In many cases, adjustable-rate mortgages (ARMs) come with rate caps that limit how much the interest rate can increase at any given time or overall. Periodic rate caps limit the amount by which the interest rate can fluctuate from one year to the next, whereas lifetime rate caps limit the amount by which the interest rate can rise or increase over the life of the loan.

Notably, some ARMs have payment caps that limit the dollar amount by which the monthly mortgage payment can increase. Negative amortization may result if your monthly payments are insufficient to cover the new interest rate being charged by your lender. With negative amortization, the amount owed can continue to increase even if the minimum monthly payments are made.

Is adjustable-rate mortgage (ARM) a bad idea?

ARMs (adjustable-rate mortgages) are not suitable for everyone. Yes, their attractive introductory rates are attractive, and an ARM could help you qualify for a larger mortgage loan. However, it is difficult to budget when payments can fluctuate wildly, and if there are no interest rate caps in place, you could get into serious financial trouble if interest rates spike.

How are ARMs calculated?

After the initial fixed-rate period expires, the cost of borrowing will fluctuate based on a reference interest rate, such as the London Interbank Offered Rate (LIBOR), the prime rate, the Secured Overnight Financing Rate (SOFR), and the rate on short-term U.S. Treasuries. In addition, the lender will add its own fixed amount of interest, known as the ARM margin, to be paid.

When did ARMs first become available to homebuyers?

In the early 1980s, Americans were given the option to obtain a long-term mortgage with variable interest rates for the first time.

Previous attempts to introduce such loans in the 1970s were thwarted by Congress out of concern that they would result in mortgage payments that were unmanageable. Later in the decade, however, the decline of the thrift industry prompted authorities to reconsider their initial resistance and become more accommodating.

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