What Is an Adjustable Rate Mortgage?
Adjustable-rate mortgages, or ARMs, are home loans with fluctuating interest rates. The main difference between adjustable and fixed rate mortgages is that conventional mortgages keep the same rate for the life of the loan. ARM rates today might differ from those tomorrow, as they adjust periodically, based on an interest rate index and a margin added by the lender. Your payment increases when the index rises and, depending on your loan terms, it might decrease if the index falls.
The initial interest rate on an ARM is usually less than that of a fixed-rate mortgage. That rate might apply for as short as a month or as long as several years, and the mortgage loan itself usually runs for 30 years.
If your ARM has a conversion clause, you’re allowed to convert it to a fixed rate when the first adjustment period ends. Lenders typically charge a fee to include this clause.
Related: Apply for a Mortgage Loan Today
ARM Types
A variable rate mortgage comes in three following options:
Hybrid ARM
Combines a fixed-rate and an adjustable-rate period. The fixed period usually runs between three and 10 years, after which your interest rate can change every year.
Interest-Only ARM
Make the interest payments only for a pre-set number of years, usually between three and 10. Your initial payment is low because you’re not paying on the actual loan balance. It increases at the end of the term, even if the interest rate remains the same, because you start paying on the principal.
Payment Option ARM
Provides flexibility on the amount of your monthly payments. You can make an interest-only payment or pay toward both the principal and interest. You can also opt to pay less than the interest due. The unpaid interest is added to the principal. Doing this near the end of your loan often results in a larger, or “balloon payment”, when it ends.
ARMs come with two different types of caps:
- The periodic adjustment cap, which limits fluctuation of ARM rates after the first adjustment.
- The lifetime cap, which limits the amount of the interest rate increase over the full life of the loan.
Some ARM’s also have payment caps that limit the amount your monthly payment rises when there’s an adjustment.
How Do You Get an ARM?
The Federal Housing Authority offers ARMs, as do financial institutions like banks, mortgage companies and credit unions. If you need assistance finding a loan, a broker can contact multiple lenders on your behalf.
The requirements for a variable rate mortgage are similar to those for a conventional home loan. However, for an ARM, the lender considers your repayment ability, based on the fully indexed rate or the greatest amount you’ll be required to pay within the first five years.
Why Would Someone Want an Adjustable-Rate Mortgage?
ARMs are good for those who don’t plan to keep their homes beyond the initial term or if a fixed rate loan is initially too costly. You might also choose an ARM if you expect your income to climb. If you face large future expenses, like college tuition or other loans, or if you’re not sure you’ll maintain an appropriate income level, exercise caution before committing to an ARM.
If you’re considering an adjustable-rate mortgage vs. fixed rates, ask potential lenders these key questions:
- When and how frequently will you adjust the ARM rates?
- What is the index and margin controlling the interest rates on my mortgage?
- What are the rate caps for this loan?
- Will you recalculate my payment every time interest rates go up to avoid increasing my loan balance?
- Can my interest rate potentially go down, and is there a “floor rate” limiting how much it can drop?
- Is there a pre-payment penalty on this ARM?
Related: Average Mortgage Rates in the U.S.
