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What is an ARM Loan?
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An ARM mortgage is a home loan with an interest rate that can change. Adjustable-rate mortgages (ARMs) may start with lower interest rates and monthly payments than their fixed-rate counterparts. They typically have an initial rate that’s fixed for a period of time. After that initial period ends, your interest rate could go up, go down or stay the same.
Below, learn how an adjustable-rate mortgage works and whether it’s right for you.
How does an ARM loan work?
With an ARM mortgage, an initial interest rate is offered that is typically lower than the going rate for a fixed-rate mortgage. After a specific amount of time, the interest rate changes based on a formula used by the lender.
Adjustable-rate mortgages can vary in how they are structured, but here are the basic features of ARMs.
Structure of an ARM loan
- The initial rate and payment: The introductory rate and payment on an ARM home loan stay in effect for a specific amount of time, generally ranging anywhere from one month to 10 years.
- The adjustment period: This refers to the amount of time between rate changes. With most ARMs, rates can change monthly, quarterly, annually or every three or five years.
- Index: The index is a measure of interest rates that lenders use. Generally, if the index goes up, interest rates go up, too. If the index goes down, rates will go down.
- Margin: The margin refers to the extra amount of percentage points a lender adds to the index to determine the interest rate you will pay, which is called the fully indexed rate.
The index added to the margin equals your fully indexed rate. For example, if the index your lender uses is currently 3% and your lender’s margin is 3%, then the fully indexed rate would be 6% (3% + 3%). If the index rose to 5%, then the fully indexed rate would be 8% (5% + 3%). If the rate dropped to 2%, then the fully indexed rate would be 5% (2% + 3%).
Margins vary by lender, and not all ARMs adjust downward, so be sure to know the details of how your loan is structured.
Types of ARM loan terms
Most ARM loans are actually hybrid ARMs. They combine features of a fixed-rate mortgage with those of an adjustable-rate mortgage. They’re expressed with two numbers, like 3/1. The first number is the length of your fixed-rate period. The second number is how often the rate will adjust after the initial period.
If you see ARMs advertised as 2/28 or another larger number, that indicates the number of years the rates will be adjustable. They could adjust every six months rather than annually. If you have questions about exactly how a specific ARM works, ask the lender or review your loan estimate.
3/1 ARM
A 3/1 ARM has a fixed rate for the first three years. After that, the lender can adjust rates annually based on the performance of the index it uses.
5/1 ARM
A 5/1 ARM has a fixed rate for the first five years and adjusts annually after the initial period ends.
7/1 ARM
A 7/1 ARM has a fixed rate for the first seven years and adjusts annually after that.
10/1 ARM
A 10/1 ARM has a fixed rate for the first 10 years. After that, it adjusts annually.
3 types of ARM loans
Borrowers choosing an adjustable-rate mortgage have three types to choose among, and each one is structured differently. Here’s how they work.
Hybrid
As noted above, with hybrid ARM loans, the interest rate is fixed for a specific amount of time and then adjusts for the remaining loan term. For example, a 30-year 10/1 ARM has a fixed rate for the first 10 years and then changes annually for the remaining 20 years.
Interest-only
With an interest-only ARM mortgage, borrowers can pay only the interest due on the loan for a specific amount of time, usually anywhere from three years to 10 years. After the interest-only period, payments increase to include the principal for the remaining loan term.
For example, a 30-year ARM with a three-year interest-only period will have interest-only payments for the first three years, and then payments will include principal and interest for the next 27 years.
Payment option
In a payment-option ARM, borrowers choose among multiple payment options each month which typically include the following:
- Principal and interest. These are traditional payments that reduce the principal owed on the loan and are usually based on a set loan term such as a 15- or 30-year payment.
- Interest-only. These payments go toward the interest only and do not reduce the amount owed on the mortgage.
- Minimum (or limited) payment. These payments may not be large enough to cover any principal on the loan or all of the interest due. Any unpaid interest will be added to the principal, increasing the total amount of the loan as well as the total interest paid and will result in larger future payments.
What drives ARM rates?
The rates for adjustable-rate mortgages are based on an index plus the lender’s margin to total the loan’s indexed rate. Let’s take a deeper look at how that works as well as other factors that affect ARM mortgage rates.
Caps
A cap is the most your interest rate or monthly payment can increase. There are four types of caps that affect adjustable-rate mortgages.
- Initial adjustment caps. This is the most your interest rate can increase the first time it adjusts.
- Subsequent adjustment caps. These caps limit the amount your interest rate can increase in one adjustment period after the initial adjustment. If the index rate increases but can’t be fully applied in one period due to the cap, your rate may increase the next period, which is called carryover.
- Lifetime caps. These caps limit the amount your interest rate can increase over the life of your loan. Nearly all ARMs have a lifetime cap, according to the Consumer Financial Protection Bureau (CFPB).
- Payment caps. These limit the amount your monthly payment can increase at each adjustment.
Economic indexes
An index is a benchmark variable rate that’s used to establish the interest rate of an ARM mortgage. Indices change based on economic conditions. The three most common indices used for ARM mortgage rates are:
- One-year constant-maturity Treasury (CMT) securities
- The Cost of Funds Index (COFI)
- London Interbank Offered Rate (LIBOR)
The LIBOR is being phased out, however. “The banks who were LIBOR based have either retreated back to the Treasury-based index,” says Melissa Cohn, executive mortgage banker with William Raveis Mortgage. “Or they go to the new one they’ve called the SOFR index.”
According to Cohn, the Secured Overnight Financing Rate (SOFR) is similar to LIBOR, but instead of adjusting annually, adjustments are every six months.
Margin
Lenders add a few percentage points on top of the index. This is called the margin. Lenders may base your margin, at least in part, on your credit history.
Adjustable-rate mortgage pros and cons
If you’re considering an ARM mortgage, consider the benefits and drawbacks.
Pros
Lower interest rates. The initial or introductory rate of an ARM is typically lower than the rates of fixed-rate loans, providing some upfront savings.
Lower payments. When compared with a fixed-rate mortgage for the same loan amount, ARMs typically start off with lower payments. But keep in mind that the payment could go up.
More buying power. An adjustable-rate mortgage can allow a borrower to buy more home than they could with a fixed-rate mortgage with the same payment amount.
Potential long-term savings. If interest rates remain low for a good portion of the loan, then the cost of the loan would be cheaper than a fixed-rate mortgage.
Cons
Lack of predictability. Once the fixed period ends, there’s no way to know exactly how interest rates will move.
Potential higher costs. Depending on how interest rates move, you could pay significantly more in interest over the life of your ARM loan.
Confusing terms. These products are complex; it’s critical to thoroughly review your loan disclosure document and ensure you’re comfortable with the terms.
Negative amortization. If you opt for an interest-only or payment-option ARM, you could owe more than the amount you borrowed.
ARMs vs. fixed-rate mortgages
Is an ARM or a fixed-rate mortgage (FRM) better? That depends on your preferences and your circumstances. Here are a few considerations.
An ARM is best for you if …
- You don’t plan to stay in your home long. Borrowers who “don’t expect to be in their home for the rest of their life and they know that it’s short term,” could do well with an ARM, according to Cohn. They could very well move before the end of their initial fixed-rate period.
- You know your income will increase. For example, “Someone who’s just out of professional school, [such as] a doctor or a lawyer, who…really wants to take advantage of the lower monthly payment with an adjustable-rate [mortgage],” says Cohn.
- You’re taking out a jumbo loan. The money you save with an ARM makes a bigger impact with a larger mortgage. The potential risks may be worthwhile for the significant savings if you’re confident you’ll sell or refinance before the end of your initial, fixed-rate period.
An FRM is best for you if …
- You’re on a tight budget. If the monthly payment during the initial period of an ARM mortgage is near the top of your budget range, consider a fixed-rate mortgage instead. There’s always a chance that the monthly payment will increase with an ARM.
- You prefer predictability. There’s an element of risk with an ARM. A fixed-rate mortgage eliminates that risk.
- You’re planning to stay in your home long term. ARMs work best if you’re planning to sell or refinance before the end of the initial, fixed-rate period. If you’re planning to stay in this home for the long haul, a fixed-rate mortgage may be best.