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What Is an Adjustable Rate Mortgage (ARM) – Definition, Pros & Cons

By Kira Botkin

adjustable rate mortgageWhen shopping for a mortgage, you have a variety of options. Mortgages can be structured differently and many factors are negotiable, such as the interest rate, closing costs, the loan’s length, a pre-payment penalty, and a balloon payment, to name a few.

One type of loan that has recently become popular is the ARM, or adjustable rate mortgage. On this loan, the interest rate starts out very low and adjusts over time according to an interest index, such as the LIBOR (London InterBank Offered Rate). Typically, the interest rate adjusts up because a margin is added to whatever current rates are.

ARMs can be very appropriate in certain situations and can invite foreclosure in others. Therefore, it’s essential to understand their unique features and consider the long-term risks in addition to the short-term rewards that this type of loan has to offer.

Perhaps the most important considerations regarding an ARM pertain to whether there is a fixed interest rate period, what index the rate is based on, how often the rate adjusts, and whether there are interest rate or payment caps.

Fixed Interest Rate Period

The most common adjustable rate mortgage is called a “hybrid ARM,” in which a specific interest rate is guaranteed to remain fixed for a specific period of time. Often, this initial rate is lower than what you could otherwise get in a traditional 30-year fixed loan.

For example, a 3/1 ARM or a 5/1 ARM will offer a fixed interest rate for three or five years, respectively. However, the fixed period can vary greatly, from one month up to ten years, and it’s only limited by what the lender will allow. Generally, the shorter the fixed period, the lower the interest rate will be during that time.

For the many people who refinance their mortgage or move every few years, an ARM can be an effective way to pay less in interest than would be possible with a standard 30-year fixed loan. Moreover, this fixed period can give you time to assess what direction interest rates are heading, and decide when or if to refinance. That said, most people choose to refinance at or near the end of the fixed rate period.

How the New Interest Rate Is Calculated

Your mortgage interest rate will adjust according to a specific interest rate index and the lender’s margin.

Interest Rate Index

Buried somewhere in the paperwork for every adjustable rate mortgage, you’ll find the index that the interest rate’s adjustment will be based on. An index is a general indicator of current interest rates, such as the current rate on Treasury bonds or the interest rate that banks pay on their deposits (COFI).

When interest rates go up, these indexes will go up. Likewise, when interest rates go down, these indexes will go down. However, though each index will follow the general trend, they may not exactly track current average interest rates.

Margin

The margin is the percentage added to the index to determine your new interest rate, and it generally runs between 2% and 4%. For example, if the index averages 4% and your margin is 3%, your rate will adjust to 7%. The index plus margin is technically referred to as the “fully indexed rate,” but most people just call it your interest rate.

Margins are added so that the lender makes a profit because the indexes used commonly have very low rates. The size of your margin can also be dependent on your credit; the better your credit, the smaller the margin. Because of the margin, interest rates will typically have to go down (compared to when you took out the loan) to see an equivalent or reduced interest rate once your ARM adjusts.
When comparing ARMs, keep in mind that the one with the largest margin is not necessarily the loser. This is because it may be using an index that is generally lower, or has less volatility. For example, some mortgages will base the interest rate on the COFI (Cost of Funds Index), which tends to go up and down less than other rates. Instead, some ARMs use the LIBOR, which tends to be a little higher. Look at where the ARM’s index has been over the last several years in order to get an idea of where your interest rate may be in the future.

How Often Does the Interest Rate Adjust?

Once the interest rate adjusts, you need to know how often it will change going forward. In other words, when is the next time it will adjust? Knowing this is crucial not only to help you make a budget, but also to determine when it’s time to refinance.

To know when this will occur, look at the second number of the hybrid ARM. For example, you already know that a 3/1 ARM will adjust for the first time after three years. However, the second number indicates that it will adjust once every year thereafter. That said, there are some ARMs that will adjust every two years, six months, or even every month after the initial adjustment – though the latter is less common.

red house interest rates

Is the Interest Rate or Payment Capped?

A cap on your interest rate or payment means it can only go up a certain amount over a certain time period. In fact, there are different kinds of caps which are designed to keep your payment or interest rate from going up drastically over a short period of time, even if interest rates spike.

Interest Rate Cap

Interest rate caps come in two flavors: lifetime caps and periodic adjustment caps.

  • A lifetime cap keeps the interest rate from ever going above a certain rate (this limit can be quite high).
  • A periodic adjustment cap keeps the rate from going up too much in a specified time period. For example, your interest rate may be limited to gain 0.5% per year, no matter how much the index has risen. However, some ARMs will not place a cap on the first adjustment, but will on subsequent adjustments.

One important caveat is that if the index goes up more than the cap amount in one year, the interest rate can continue to adjust the next year even if the index hasn’t moved since the previous adjustment.

So in the example above, let’s imagine the index has risen 1.5% in one year, but stays at that level for the next few years. In year 1, your interest rate goes up 0.5%, or the amount your periodic adjustment cap will allow. Then, in years two and three, the interest rate will rise 0.5% until your interest rate matches the index plus margin amount.

Interest Rate Floor

Some ARMs have a “floor” interest rate below which the rate cannot go. In other words, even if interest rates decline substantially, your new rate may not decline at all. This is because the “floor” could be the interest rate effective during the fixed period, or the interest rate that it first adjusted to. Check your paperwork carefully to see if you have an interest rate that will only go up.

Payment Caps

Like the interest rate cap, a payment cap keeps your payment from going up too much at any one time. Payment caps will either be in dollar amounts (e.g. your monthly payment can only go up $200 each year) or a percentage (e.g. your monthly payment can only go up 10% each year).

Moreover, your new payment will be compared to the previous year’s payment, not the original. For example, if your payment cap is 10% each year, and you initially paid $1,000/month, your adjusted payment could increase to no more than $1,100 in the first year, $1,210 in the second, and $1,331 in the third.

Payment caps usually operate independently of interest rate caps. So even if the interest rate goes up substantially, that doesn’t necessarily mean your payment will. On the flip side, however, you still owe that interest and it will be tacked on to the balance of your mortgage. This is known as negative amortization (see below).

In fact, you may not even realize it’s happening. But if your interest rate goes up and your payment doesn’t, your loan balance is probably going up instead of down each month. Some ARMs carry a clause that will remove the payment cap entirely when the current loan balance exceeds the original loan balance by a specific amount. This often results in a huge payment jump. To avoid this situation, review your mortgage statement every month to make sure your loan balance isn’t increasing and that your payment corresponds to the interest you’re being charged.

Different Types of ARMs

In addition to the hybrid ARM, there are other less common types. If misunderstood, these can have serious consequences to your financial health, credit, and overall quality of life.

1. Interest-Only ARMs

An interest-only ARM allows you to pay just the interest on the loan each month, without paying down any principal. This lowers the payment, but does nothing to help you build equity or come any closer to owning your home outright. This type of loan is often used by investors who don’t intend to keep the home for long, or by homeowners who expect to better afford their home in a few years.

However, taking on such a loan can be risky business since most interest-only mortgages eventually reset and require you to pay down the principal as well. When this happens, of course, the payment rises dramatically. If you have or are considering such a loan, understand how and when it adjusts to be fully amortized.

2. Negative Amortization Mortgages

“Negative amortization” is a fancy term for a mortgage where you pay less than the interest due each month. It means that your loan balance rises because unpaid interest is added onto the loan balance. These types of mortgages were commonly abused during the housing boom because payments are understandably low.

However, if the loan balance gets too high, the mortgage will reset and payments will jump dramatically. Before the housing boom, most negative amortization mortgages were used only by investors or house flippers. These loans simply are a recipe for disaster for most homeowners.

3. Payment-Option or Pick-a-Pay Mortgages

The “pick-a-pay” mortgage, also known as a payment-option mortgage, is a fairly new type of loan that seems tailor-made to create problems. These mortgages were very popular when home prices were rising dramatically because they allowed people to get into more house for less money. Most of these loans offer multiple payment options each month and as long as you pay at least the smallest payment, you will not be in default.

Commonly, you can choose between paying all the interest plus some of the principal, paying interest only, or paying an amount that is less than the interest accrued that month. You can imagine that most people choose the smallest payment, which means the unpaid interest can cause the loan balance to grow substantially over time. Then, once the loan balance reaches a certain point (often 20% more than the original balance), the mortgage will reset and the payments will go up dramatically.

Pick-a-pay mortgages were often sold to people who weren’t informed that paying the minimum payment would cause their loan balance to grow. While these types of mortgages can be a great tool for investors, they usually are not appropriate for people who intend to be in their home a long time. If you have a mortgage with different payment options each month, carefully read your loan documentation and your mortgage statement to determine how much you need to pay in order to keep your loan balance going down instead of up.

house charts

Pros and Cons of ARMs

These pros and cons apply generally to most ARMs, but examine your paperwork carefully to confirm whether or not they apply to the loan you are considering.

Advantages

  1. Lower Closing Costs. One significant benefit to ARMs is that they are often cheaper than a mortgage with a permanently fixed interest rate.
  2. Lower Fixed Interest. If the ARM has a period with a fixed interest rate, that rate is usually lower than the rate on a permanently fixed interest rate mortgage.
  3. Generous Fixed Interest Period. Since many people don’t even keep the same mortgage for five years, a 5/1 ARM may give you plenty of time to sell or refinance your home without your initial rate ever adjusting. This means you could save money up front on lower closing costs and over time through lower interest rates – especially if the interest rate environment remains low or declines.
  4. Helps You Qualify for a Bigger Home. Because the initial payment is often lower than that of a mortgage with a permanently fixed rate, it can be easier to qualify for a larger loan. Many people who get an ARM are first-time homebuyers who expect to earn more money in five years than they do now. In fact, an ARM can be a great stepping stone into home ownership since it is relatively low-cost and easy to qualify for.

Disadvantages

  1. Lack of Consistency in Payments. Once the rate adjusts, it can make budgeting difficult, especially if your rate adjusts every month or six months.
  2. Interest Rates Could Rise. In a hybrid ARM, the interest rate during the fixed period is often artificially low. So even if rates don’t change much, your payment could still go up when the interest rate resets. If interest rates have risen, your rate could increase to your cap amount, which, in some cases, could result in negative amortization.
  3. You Could Forgo a Low Fixed Interest Rate. Though the interest rate on an ARM will initially be lower than that of a 30-year fixed mortgage, it will reset. If interest rates rise before you refinance, you could miss out on 30 years of a lower interest rate.
  4. More Likely to Have Hidden Problems. Unfortunately, mortgage providers have proven not to be the most ethical group and have a tendency to abuse certain mortgages, such as ARMs. In other words, you’ll have to make sure you’re not missing anything in the fine print and that you understand the terms of the loan like how the margin, payment and interest cap, and interest floor work. Many homeowners have found themselves in hot water and even in bankruptcy due to this type of loan.

Final Word

Adjustable rate mortgages have increased greatly in popularity the last several years, primarily because of their lower costs and interest rates. However, they’ve been seriously abused as well. Still, an adjustable rate mortgage that is tailored to fit you and your financial needs can be very beneficial as long as you are aware of all of the terms of the mortgage.

Moreover, when choosing any mortgage, and especially an ARM, consider your personal situation and intent. For example, if you expect to live in your home for many years and interest rates are at all-time lows, an ARM may not make sense for you. Sure, you’ll save some money in the first few years, but chances are you’ll pay more via a higher interest rate when you refinance.

Take the time to understand and comparison shop for mortgages and keep in mind what features are most important to you. Always review loan documentation thoroughly before signing to ensure you’re getting the right mortgage and to avoid pitfalls and expensive mistakes.

Did you choose to go with an adjustable rate mortgage? Why or why not?

(photo credit: Shutterstock)

Kira Botkin
Kira is a longtime blogger and serial entrepreneur who enjoys gardening, garage sales, and finding stray animals. She lives in Columbus, Ohio, where football is a distinct season, and by day runs a research study for people with multiple sclerosis. She hopes that the MoneyCrashers team can help you achieve your goals and live a great life.

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