Adjustable-Rate Mortgages (ARMs)  – What Is It And How it Works?

Adjustable-Rate Mortgages (ARMs)  - What Is It And How it Works?An adjustable-rate mortgage (ARM) is a mortgage loan that has interest rates that adjust according to a certain index.

What does it mean “a certain index”?

That index is based upon the cost that goes to the lender for borrowing from the credit markets. Adjustable-rate mortgages are often called variable-rate mortgages and/or a tracker mortgage.

Let’s explain:

Typically, these loans are offered at the lender’s base rate. Often times, there is a legally defined link to the hidden index, but sometimes there is not. In the United States, these are mainly called “adjustable-rate mortgages”. Outside the United States, though, these are often referred to as “variable-rate mortgages”  or “floating rate mortgage”.

What Is An Adjustable-Rate Mortgage (ARMs)

Market indexes determine your rate on the mortgage.

For instance:

Alot of adjustable rate mortgages are connected to LIBOR, Cost of Funds Index, other indexes, as well as prime rates. While these mortgages are based on technicalities, it will have an effect on how your payments differ.

Be sure to ask the lender questions on what/why they recommend one over the other.

ARMs Take A Number Of Different Forms

If you agreed to have a periodic cap of 2% per year, and the rates rise to 4%, your rates would only rise to 2% because of the cap.

This brings some security.

“Lifetime caps” work similarly: If you have a lifetime cap of 7%, you can be confident in knowing the rates won’t go above the 7% you made the deal on.

Interest rates differences (in excess) can carry over from each year and impact your mortgage payment.

Let’s look at it in detail:

If we use our example of 2% above, let’s say the interest rate rose to 6%. Since we have an  ARM cap, it kept it at a solid 2% increase. That’s good, but note that if interest rates are subtle the next year, it’s possible the adjustable-rate mortgage will rise another 2%.

Why?

You still “owe” from the past cap.

Usually, ARMs signify two numbers. The first number is the time the fixed-rate is set for the loan. The second number is a bit more liberal. There isn’t really a “key” to figure out what this will mean.

Let me give you some examples:

A 3/30 ARM will have a fixed rate for three years. The “30” represents  a 30 year floating rate. Similarly, a 7/2 ARM will have a fixed rate for seven years, and a variable/floating rate every two years. Also, a 7/7 ARM has a seven year fixed rate and a seven year variable/floating rate.

It is always best to use an adjustable-rate mortgage calculator when debating ARMs.

The Different ARMs

As you can tell, there are a lot of different ARMs to choose from. You might see a few of these when shopping:

  • 8/1 ARM– Your fixed rate would be eight years, and then would adjust each year.
  • 9/2 ARM – Your fixed rate would be nine years, and then would adjust every two years.
  • 3 Year – Your rate is fixed for three years and then adjusts yearly.

***Note: Your adjustments are made until you hit a cap, if applicable.***

Indexes/Margins

When the fixed-rate period stops, the ARM’s rate moves with another interest rate. This is called the index. This index is settled by a neutral group. It also relies on market forces. Most loan documents define what index an ARM follows. However, there are a lot.

Most mortgages rely on one of three indexes:

The 11th District cost of funds index, the London Interbank Offered Rate, or the maturity yield on one-year Treasury bills.

The first thing to do is understand the rate:

ARM rates are set by a lender (See how to find the best mortgage lender) taking an index rate and adds percentage points (margin).  There are many factors what’s the rate you’ll get, the main factor is your credit score – if you still don’t know it, there are many free ways to get it.

Remember: Margins cannot change- the index rate can.

Example: The index is 1.75%. The margin is 2 percentage points. These are added together for a total of 3.75%. Later on, if the index shifts to 2%, your interest rate would increase to 4%.

Like I said, margins CANNOT change. Indexes CAN.

Another Example: The index is 7%. The margin is 3%. These add together for a 10% interest rate. If the index shifts down to 4%, your new interest rate would be 7%.

Differences in ARMs:

  • Interest-only ARMs

    This simply means you will pay the interest on a mortgage exclusively. You will pay this for a set number of years, and won’t pay the principal. These provide smaller monthly payments for      the period.These usually range from five to 10 years.

    • EX: A 7/2 ARM requires you to pay interest only for seven years. Adjustments are made every two years.
    • After the period, the loan outlays. So… it’s paid off by the term length. Be cautious: This has the ability to lead to higher monthly payments.
  • Payment-option ARM:

    This enables you to choose from payment options, such as: interest only, 15/30/40-year fully amortizing payment, or a minimum payment. This provides a series of choices for the defaulter.

  • Hybrid ARMs

    : This comes with an upfront fixed-rate cycle. The interest rate then adjusts yearly afterward. The fixed-rate cycle can be anywhere from three to 10 years, and maybe even more.

    • EX: A 3/1 Hybrid ARM has a fixed-rate for three years and then moves yearly.

Dealing With the ARMs

Dealing with these can be difficult and risky. You need to make sure you pick the right adjustable-rate mortgage. I suggest getting a loan with “caps” and rules. Again, these caps are just a “stop right here before it goes higher” mark on the ARMs.

Check the caps!

Caps can be set on the interest rate applied to a loan, or to a dollar amount for a payment. With that said… the first three years, for example, might be a guaranteed amount of years that have to pass before a rate starts moving. A lot of risks with ARMs are taken away with this. However, it can also cause other difficulties.

We went over some basics on how the ARMs work, as well as some advantages for people.  So… we need to also look at the disadvantages of them for other people.

ARM caps work in different ways. There are lifetime and periodic caps.

  • Lifetime Caps- Limit the amount the ARM rate can change over the entirety of a loan.
  • Periodic Caps- Limit how much the rate can change during an era.
  • EX: A three-year period.

Advantages:

  • Lower Initial Interest Rate- You very well could get a lower monthly payment with an adjustable-rate mortgage. Banks typically reward you with lower rates since you are taking the risk that interest rates could rise later on. With fixed-rate mortgages, the bank takes the risk.
  • Lower Monthly Payments- After the fixed-rate period, interest rates can sink. Therefore, lower monthly payments.

Disadvantages:

“…and then he proposed a business idea… with ‘no down-sides!’”…

Anything that has to do with business, finance, or anything related will always have a downside.

  • Unpredictable Interest Rates- I wish there was a way to know what your payments will be in the future, but you can’t. Your monthly payments can decrease. Likewise, they can also increase! So you also run that risk! If you can’t afford it, then what happens? That’s right, the inevitable: debt (See how to consolidate your debt).
  • Higher Payments- You can benefit from the lower payments, duh, but you also have the risk of rates increasing. Then, higher payments.

Final Words

I urge you to evaluate ALL of your options and decide what is best for you. These lower payments do seem very enticing, but you should never “just do it” without knowing that if they increase substantially, you can still afford it. Review your options, then go from there.

 

 

 

 

 

 

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Baruch Silvermann

Investment research writer, business journalism, and financial analyst. Covers the vast spectrum of the financial topics in investments, real estate, equities, fixed income and personal finance. Twitter: https://twitter.com/BSilvermann