What is an Adjustable Rate Mortgage (ARM)?
By Arvin Sahakian · Jun 8, 2015 · Mortgage
An adjustable rate mortgage has a lower rate and is fixed for a limited number of years. Understanding what makes these loans unique can help you determine if it is a good option for you.
At its core, an adjustable rate mortgage is exactly what it sounds like-a mortgage with an interest rate that fluctuates up and down based on market conditions. Usually, the rate starts lower and increases after a set amount of time-offering homebuyers a period of time to get their finances in order before the rate increases.
However, an ARM isn't right for every buyer, it's important to understand exactly how these loans work before choosing an adjustable rate for your mortgage.
Adjustable Rate Mortgage (ARM) Definition
The ARM loan option has a rate and payment that is fixed for a limited number of years, after which the rate and payments begin to fluctuate up or down. The fluctuating rate and payments will be determined by an index rate, plus a margin.
In low interest rate environments, the rates on ARM loans tend to stay low. However, in rising interest rate environments, these fluctuations can rise quickly.
How the Adjustable Rate is Determined
One of the first questions that many borrowers have when considering an adjustable rate mortgage has to do with the rate itself-more specifically: "How is the adjustable rate determined?" Two main factors determine the rate that you pay for your ARM.
These factors are:
The index is the variable portion of the rate. It is set by market conditions and published regularly by a neutral party. It can actually vary up or down.
This is an agreed-upon number of percentage points added to the index that determines your rate. This will vary depending on your personal credit score and other independent issues.
Disadvantages of Adjustable Rate Mortgages
While an ARM can be very tempting to a homebuyer, it is important that you understand the disadvantages as well as the advantages. Some of the most common disadvantages include:
Fluctuating Interest Rate
If there is a dramatic change in the market, your rate could increase substantially, resulting in what many call "payment shock."
Short Period for Fixed Rate
This can make it difficult to prepare for changes and can cause financial distress for some borrowers, especially when you must shop
around for a new mortgage to refinance the exiting ARM loan.
Advantages of Adjustable Rate Mortgages
Despite the disadvantages, there are many appealing things about this loan option as well. Some of the reasons you may want to consider an ARM loan include:
Lower Rates than Fixed Term Loans
Often the interest rate is much lower in the beginning of the loan term than a fixed rate loan, such as a 30 year fixed.
Ideal if Moving from Home Soon
If you know you will not be in the home for a long time, the ARM could be the ideal solution for your circumstance.
Example of ARM Payments
One of the best ways to understand how a mortgage will work is to see an example. There are different ARM structures which determine how long the rate is fixed before it is able to adjust.
One example is a 5/1 ARM (fixed rate for 5 years)
If you borrow $400,000, and your initial interest rate is 4%, your starting monthly payment would be $1,910 (fixed for 5 years).
ARM loans usually have an interest rate cap
- Your rate cannot adjust up more than a predetermined amount, no matter what the index and margins is (this info. will be in your mortgage disclosure documents)
- If your cap is 9%, the maximum your monthly payment would ever be is $3,218.
- In most cases, you will not see the ARM rate rise to this level very quickly-under normal circumstances, changes in interest rate occur gradually.
Adjustable rate mortgages are fixed for a limited amount of time. They typically have lower rates than permanent fixed loans and can be a useful tool for well-informed homebuyers who weigh the advantages against the disadvantages.
ARM loans can also be very tricky to work with. Understanding your financial circumstance as well as how the loan works is the key to making sure you are prepared to take on the responsibility of this type of loan.
Remember, ARM loans are fixed for a limited time, so do not simply choose the ARM loan only due to the lower payment, especially if you intend on staying in the home for a long time.
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