Adjustable rate mortgages (ARMs)

by Elizabeth Rosen, Contributor

There are 2 very basic types of mortgage loans, those with fixed interest rates and those with adjustable interest rates (ARM).

Sometimes called a “variable rate mortgage” or “floating rate mortgage,” an adjustable rate mortgage (ARM) has an interest rate that adjusts periodically based on current market rates.  ARMs were created during a time of high interest rates when many people could not qualify for fixed rate mortgages. With ARMs, mortgage lenders can offer low initial rates in exchange for sharing the future risk of higher interest rates with the borrower.

Adjustable-rate mortgage loans are generally more complicated than fixed-rate mortgages and they come in a variety of shapes and sizes. The easiest way to understand how ARMs work is to look at their basic features.

Adjustable rate mortgage loans have 2 distinct phases:

Initial Rate and Payment

Adjustable rate mortgage loans typically start out with lower interest rates and monthly payments than comparable FRMs. This initial fixed-rate period may be 1 month to 10 years long, depending on the particular loan agreement. Lower initial rates allow more borrowers to qualify for ARMs, but keep in mind that you are assuming the risk of higher mortgage rates (and thus higher payments) in the future.

Adjustment Period

Once the initial fixed-rate period ends, the ARM’s interest rates will change periodically (monthly, quarterly or annually) for the rest of the mortgage loan term, which may be 5, 10 or 30 years. The rate adjustments are based on the fluctuations of a specific mortgage index.  How often the rates change will depend on your particular loan contract. Each time an adjustment date comes up, the lender finds out the index value, adds a margin, and then recalculates the new loan rate and payment.

There are 3 major features of every adjustable-rate mortgage loan:

Index

The interest rate for an ARM is periodically re-set based on the performance of a mortgage index. In general, a lending institution will use one mortgage index for most of its products. While there are many different indexes used by lenders around the world, the following 5 are the most commonly used in the United States:

  • Prime Rate (The Federal Reserve’s U.S. Prime Interest Rate)
  • LIBOR (London Interbank Offered Rate)
  • COFI (11th District Cost of Funds Index)
  • CMT (Constant-Maturity Treasury)
  • MTA (12-Month Treasury Average)

Make sure you know which index your lender is using ― this usually established during mortgage loan application. If the index’s value rises, your interest rate and monthly payments will increase as well. Keeping an eye on the index can help you plan for payment fluctuations.

Margin

The margin is an extra amount that the lender charges based on the risk associated with the loan. For most ARMs, the mortgage index is used as a base lending rate and then a margin is added to determine the loan’s “fully indexed rate.” Unlike the index, the margin is not affected by market conditions and it’s typically fixed throughout the life of the loan. However, the margin amount may vary from lender to lender depending on the mortgage loan program ― usually it adds a few percentage points to the index rate. The larger the margin is, the higher your monthly payments will be.

Rate Cap

Most ARMs come with a rate or payment cap to protect consumers from massive increases in their monthly payments.

There are 3 types of ARM caps:

  • Adjustment Cap ― Limits how much the interest rate can rise during each adjustment period.
  • Lifetime Cap ― Limits the amount that rates can increase over the life of the loan.
  • Payment Cap ― Limits how much the monthly payment can rise.

While the adjustment and lifetime caps are generally effective consumer safeguards, be wary of the payment cap (only offered with some types of ARMs) because it may prevent your monthly payments from increasing enough to keep up with the loan’s interest rate. This will lead to negative amortization and higher payments in the future.

Adjustable-rate mortgage loans are best for people who need affordable payments in the beginning, but can handle the risk of rising payments in the future. Homebuyers who expect an increase in their income or who don’t plan on staying in their house for longer than 5 to 7 years (before the initial rate period ends) may want to consider an ARM.

Often times, homebuyers select adjustable rate mortgages because they don’t qualify for a traditional fixed rate mortgage and/or they’re tempted by the affordability of the initial rate period. While ARMs are most popular when interest rates are high, don’t choose an adjustable rate mortgage loan because you think rates will fall. You must be sure that you can afford the loan with your future income, even if the interest rate and monthly payments increase.

1-Year Adjustable-Rate Mortgage Loan

A 1-year ARM has an adjustment period of one year, meaning the interest rate and monthly payments will be adjusted once every year throughout the loan term (typically 30 years). This type of loan does not have an initial fixed-rate period. It is considered quite risky because your payments can change dramatically from year to year. As of April 15, 2010, the average U.S. mortgage rate for a 1-year ARM was 4.13% (source: Freddie Mac Primary Mortgage Market Survey®).