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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. ARMs  - What Is It And How it Works?

You can trust the integrity of our unbiased, independent editorial staff. We may, however, receive compensation from the issuers of some products mentioned in this article. Our opinions are our own.

Table of Content

When it comes to choosing a mortgage, you must weigh a variety of personal concerns against the economic realities of an ever-changing market. Individuals' personal finances frequently endure ups and downs, interest rates rise and fall, and the economy's strength waxes and wanes.

If you're thinking about getting an ARM, run the calculations to see what the worst-case situation is. An ARM will save you money every month if you can still afford it if your mortgage resets to the maximum cap in the future. If you compare a variable-rate mortgage to a fixed-rate mortgage, you should use the savings to make extra principle payments each month so that the total loan is smaller when the rate resets, decreasing costs even more.

If interest rates are high and predicted to fall, an ARM will allow you to benefit from the decrease because you are not locked into a specific rate. A fixed-rate mortgage may be the best option if interest rates are rising and you want a consistent, predictable payment.

According to data obtained from Freddie Mac, the interest rate on a 30-year conventional mortgage has been on a gradual decline. In 1975, the rate of the 30-year conventional mortgage was 13.74%, and it has declined to 3.08% in 2021. Mortgage lenders lower mortgage rates as a way of stimulating growth in the housing market.

Chart: Rates on 30-Year Conventional Mortgage in the U.S. 1975-2021

What Is An Adjustable-Rate Mortgage (ARMs)

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.

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”.

For example, 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.

Adjustable Rate Mortgage – Example

Let's start with a short intro about what exactly is cap. So, cap refers to the maximum increase in the interest rate that can be made during each adjustment period. Some ARMs also have payment caps on the overall amount due each month. 7 These loans, also known as negative amortization loans, have modest monthly payments, but only cover a fraction of the interest owed. Interest that is not paid is added to the principal. Your principle owing may be more than the amount you originally borrowed after years of payments.

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. “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.

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.
For example, 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.

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.

It is always best to use an adjustable-rate mortgage calculator when debating ARMs. ARMs, or adjustable rate mortgages, are similar to fixed rate mortgages in that you pay a portion of the principle amount each month, as well as interest. If you have an interest-only ARM, this is an exception. This option allows you to pay simply the interest for a set period of time before moving on to the principal and interest. You should keep in mind that while your payments will be smaller during the interest-only period, they will skyrocket once you begin paying the principle.

What Happens When the “Fixed” Period Stops?

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 to understand the rate:

ARM rates are set by a 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.

For 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%. Remember: margins can't 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%.

What Are The Different Options of ARMs?

1. 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.
For example, 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.

2. 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.

3. 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. For example, a 3/1 Hybrid ARM has a fixed-rate for three years and then moves yearly.

How to Handle Your ARM?

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.

Caps can be set on the interest rate applied to a loan, or to a dollar amount for 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.

Should I Consider Adjustable Rate Mortgage?

When answering the question, you should understand the pros & cons of taking an ARM, as well as  more parameters, depends on your personal situation:

  • 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.
  • 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?
  • Higher Payments – You can benefit from the lower payments, duh, but you also have the risk of rates increasing. Then, higher payments.

Fixed Vs ARM: How To Choose?

A fixed rate mortgage differs from an adjustable rate mortgage in that the interest rate is established when the loan is taken out and does not vary. The interest rate on an adjustable rate mortgage might go up or lower.

Many adjustable rate mortgages (ARMs) begin with a lower interest rate than fixed rate mortgages. This initial pace may remain constant for months, a year, or even several years. When the promotional period ends, your interest rate will change, and your payment amount will most likely increase. 

A portion of the interest rate you pay will be linked to an index, which is a larger measure of interest rates. When the interest rate index rises, your payment rises as well. When interest rates fall, your payment may decrease, but this is not the case for all ARMs. Some adjustable-rate mortgages (ARMs) have a ceiling on how high your interest rate can go. Some ARMs have a ceiling on how low you can go with your interest rate. Be aware of how your ARM adjusts. Find out the following information before taking on an adjustable rate mortgage:

  • With each modification, how high may your interest rate and monthly payments go?
  • How often will your interest rate change?
  • What is the likelihood that your payment may increase in the near future?
  • If there is a cap on how high your interest rate could go
  • If there is a limit on how low your interest rate could go
  • If the rate and payment move up to the maximums allowed under the loan contract, would you still be able to afford the loan?

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.

FAQs

Fixed rate mortgages have the same interest rate for a set period of time, usually two to five years.  However, a set rate for ten or even twenty years is achievable.  Keep in mind, however, that a long fixed rate can have a number of drawbacks. 

Unless you lock in your rate when the base rate is exceptionally low, your fixed rate may wind up costing significantly more than the variable rate. So, before you sign up for a long-term fixed rate, consider twice

Yes, you can switch from an ARM to a fixed rate mortgage. You'll need to get some estimates and compare them to your current rate and contract, as with any refinancing. 

This will enable you to determine whether you are better off keeping with your ARM plan or switching to a fixed rate that will save you money each month and over time.

Balloon mortgages aren't as common as they were before the financial crisis of 2008/2009, hence not all lenders provide them. So, whether you can receive a balloon mortgage depends on what's available right now. In general, cheaper rates are available, but some lenders are unwilling to issue balloon mortgages because they pose a bigger financial risk.

You should seriously consider using an online mortgage application if you are a potential borrower who wants to simplify the approval process by avoiding going to branches to apply for mortgages.

This enables qualified borrowers to get pre-approval for mortgage loans online, making the mortgage process easier. You should be able to apply for pre-approval through the lender's website as long as you match the lender's eligibility criteria.

A mortgage payment is made up of five main components, despite the fact that it appears to be a simple loan payment. These are the following:

  • The principle: This is the amount of money you'll have to pay back throughout the life of the loan.
  • Interest is a percentage determined by the terms and conditions of the mortgage.
  • Taxes: This is where you pay your property taxes.
  • Insurance: You may be required to pay for both homeowner's and private mortgage insurance.
  • Many lenders bundle taxes and insurance into one large sum for payment at the end of the year, known as escrow. Because this reconciliation is done through Escrow, you may be charged Escrow costs.

FHA loans aren't just for first-time homebuyers. A FHA mortgage can be used to fund the purchase of a new house. Because of the low down payment requirements, many people assume that FHA loans are only for first-time buyers.

However, if you have little or no equity in your present house, you may be able to use an FHA loan for your next home. These loans, however, are intended for primary residences and cannot be used to purchase a second house.