What is an Adjustable Rate Mortgage?
When getting a mortgage there are two main options: Adjustable Rate Mortgages (ARM) and Fixed Rate Mortgages (FRM). An ARM is a type of mortgage where the interest rate that is not fixed for the life of the loan. With an ARM, the interest rate is only fixed for a period of time, then adjusts annually based on a few factors (described below).
Breaking it down
Generally, interest rates are lower on ARM loans initially but are replaced with a new rate after the fixed period ends. An ARM is expressed with the fixed term first followed by how often the rate changes. An ARM that is fixed for 10 years then adjusts every year is stated: 10/1 ARM.
- Lower rate during the initial term
- Allows borrowers looking to own property for less than 30 years access to lower interest rates for the same period they plan on owning.
- Potentially eliminates the need to refinance your loan. When the market interest rates are falling, your rate after adjustment periods could be lower.
- Interest-only options*
- Rates and payments can increase after the initial fixed term.
- Every ARM can have different caps, margin and index values which can be hard to understand what your rate could look like. (see below for caps, margin and index)
Types of ARMs
The different types of ARMs depend on the number of years the interest rate is fixed. The most common are 3/1, 5/1, 7/1, 10/1. The first number is the number of fixed years, and the second number is how often the rate adjusts in the number of years.
How do ARMs adjust?
The fixed portion of an ARM loan is straight forward because it is the rate on the loan estimate that’s quoted during the process. To set the ARM rate after the fixed period, the lender takes the index rate and adds the margin. The index rate can change, but the margin does not. ARMs have safeguards to protect against rates that rise too high, which are called caps.
What are caps, margins, and indexes?
Caps limit the amount the rate can change after the adjustment period.
The margin is an agreed upon percent that is the base rate in determining the interest rate after the fixed period.
Types of caps:
- The initial interest rate cap is the maximum amount the rate can adjust at the first scheduled adjustment.
- Periodic rate caps limit how much the interest rate can change from one year to the next.
- Lifetime rate caps limit how much the interest rate can rise over the life of the loan.
- Payment caps limit the amount the monthly payment can rise over the life of the loan in dollars, rather than how much the rate can change in percentage points.
An index rate is an interest rate that is tied to a specific benchmark rate that changes based on market conditions.
Common mortgage index rates:
One year Treasury Bill
*What’s an Interest-Only ARM?
An interest-only (IO) mortgage works like a regular ARM, however, during the initial fixed rate period, only interest on the principal is paid. During the interest-only period, the monthly payments will be lower as a result of only making interest payments rather than interest and principal payments. Once the IO period is over, the borrower starts to make principal and interest payments. These payments will be higher because the principal loan amount will start being paid down.
In order to qualify for an interest-only loan, lenders often require more liquid assets, higher credit scores, and greater income security.
The borrower can still make payments on the principal if they wish to on an interest-only loan granted there are no pre-payment penalties. By doing so, it increases their equity in the property, reduces principal, and reduces the amount of the payments. Before taking this action, the borrower should check with their lender to make sure there is no pre-payment penalty associated with early payments.