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What is an Adjustable Rate Mortgage (ARM)?

Posted by Andy Brikho on April 23, 2018
Andy Brikho
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If you're buying a home in the near future, you're likely going to have to apply for a home loan to finance such a large purchase. While there are several types of mortgage programs available for you to choose from, a major decision to make is whether to lock in your interest rate or choose a mortgage with an adjustable rate so your monthly payment can adjust depending on the situation.

The one you select will depend on a number of factors, including the current market and your current financial situation. Here, we'll discuss adjustable rate mortgages (ARM) to help you decide if this type of mortgage arrangement is best suited for you and your family's needs.

What is an Adjustable Rate Mortgage (ARM)?

Unlike fixed-rate mortgages whereby the interest rate is locked in for the loan term, an adjustable rate mortgage is a mortgage loan with a rate that can fluctuate regularly with today's mortgage rates. In turn, your monthly mortgage payments would go up and down as well.

Typically, ARMs start off with an initial time period in which the interest rate is fixed, followed by a separate time frame whereby the rate will fluctuate periodically at different intervals. These fixed-rate periods and adjustable-rate periods are expressed in such a way so as to help borrowers understand how long each period will last.

For instance, a 5/1 ARM means that the initial fixed-rate period is 5 years (represented by the first number). The second number means that the rate will adjust each year after that initial period over the life of the loan.

Three, five, seven and 10 years are the most common adjustable rate mortgages, which would be expressed as 3/1, 5/1, 7/1, and 10/1, respectively. That said, any number of combinations can exist.

When Do Rates Fluctuate With ARMs?

Interest rates on adjustable-rate mortgages change because they follow a rate index, which is a rate set by the financial market. There's more than just one index, and the particular one that your ARM follows will be detailed in the paperwork associated with your mortgage. This is important to note, because today's rates may differ from the rates that you will be paying in the future. To have rates solidified before ensures stability in terms of monthly payments.

Once the initial interest rate period ends, the interest rate associated with an ARM changes with the index. During the adjustable-rate period, the rate will be adjusted. At this point, your lender will calculate your new rate based on the index rate and the "margin," the latter of which is an amount that lenders add to a published index to come up with an ARM rate. While the index rate tends to change, the margin stays the same. This means that your mortgage payment may adjust slightly from your initial rate.

To determine the ARM rate, your lender will add the index and margin rates together to come up with your new rate. For instance, if the index is 4% and the margin is 1.75%, your new interest rate will be 5.75%. If the index changes to 4.25% one year later, the new rate would be changed to 6.00%.

What About ARM Rate Caps?

Borrowers may be concerned that interest rates will increase dramatically and therefore cause their monthly mortgage payments to skyrocket once the fixed-rate period is over. However, adjustable-rate mortgages come with rate caps to protect borrowers from being vulnerable to sky-high increases in interest rates.

There are different rate caps that make up the cap structure of ARMs:

  • Initial cap - This represents the maximum amount that the interest rate can adjust at the end of the fixed-rate period. For instance, if the initial interest rate is 3% and the initial cap is 1.75%, the highest that your interest rate would be able to reach after the first period would be 4.75%.
  • Periodic cap - The rate increase on every rate adjustment following the initial one is limited thanks to the periodic cap. It's the periodic cap that prevents the rate from rising too far after the first rate adjustment and going forward.
  • Lifetime cap -This cap limits the rate increase over the duration of the mortgage. If your initial rate was 3% and your lifetime cap is 4%, your interest rate would never exceed 7% despite any adjustments.

Is an Adjustable Rate Mortgage Right For You?

The choice between adjustable rate mortgages versus fixed-rate mortgages depends on a few of things; namely, the current market and interest rate, your financial position, your tolerance for risk, and how long you plan on living in your home.

If the interest rate is currently very low and expected to rise in the near future, a fixed-rate mortgage might make sense as this option would allow you to lock into a low rate and avoid any increase in rates. However, if the rates are currently high, an adjustable-rate mortgage might allow you to capitalize on lower rates in the near future if they are anticipated to drop.

Adjustable-rate mortgages might also be a sound choice if you are not planning to stay put in your home for the long haul. If you know that you're only going to live in your home for 5 years or less, you'll be able to take advantage of the low-interest rate and lower payments with less of the risk. You can realize huge savings in this particular scenario.

On the other hand, an adjustable-rate mortgage might not be a good idea for you if you don't have an appetite for risk and might not be financially capable of handling any potential increases in interest rates. ARMs are considered riskier than fixed-rate mortgages because your monthly payment could drastically change. If you like static payments that coincide nicely with your budget, perhaps a fixed-rate mortgage might be best.

Ultimately, the choice you make should be done only after sound assessment of both your finances and the current market. Speak with a seasoned mortgage broker to help you weigh the pros and cons of an adjustable-rate mortgage before you make your final decision.

Topics: ARM, Mortgage Types