What Is an Adjustable Rate Mortgage (ARM)?

Adjustable Rate Mortgages: Flexibility and Risks Explained

While fixed-rate mortgages are the more popular option, ARMs are a viable choice for a home loan. The housing market’s fluctuating interest rate may be beneficial despite the added uncertainty. This article will cover the basics of adjustable-rate mortgages, how they work, the difference between ARM and fixed-rate, and more.

What Is an ARM?

ARM stands for an adjustable-rate mortgage, one of the two major programs for conventional home loans. An ARM loan begins with a fixed-rate period, during which the interest rate will not fluctuate, providing a predictable payment amount. After this period ends, the rate will adjust according to an index, such as the U.S. Treasury rates, plus the lender’s determined margin. It can then be adjusted by intervals of one, three, five, or ten years. ‍

How Does an ARM Work?

Adjustable-rate mortgages work like fixed-rate mortgages for the first three months to ten years. After the agreed-upon period, the interest rate will adjust to match an index, often the U.S. treasury rate. There will also be a margin of interest, which the lender will determine. 

It is common for lenders to cap the maximum or minimum mortgage payment fluctuation, ensuring no extreme rate hikes. Besides the rate changes, ARMs function like conventional loans in terms of payments, amortization schedules, and PMI.

Benefits of an ARM 

Although they may appear risky, ARMs offer some appealing benefits in certain situations. Often, an ARM loan has lower interest rates. This is perfect for homebuyers who plan on selling before the fixed period expires. For market-savvy individuals who believe rates will decrease, it gives them an opportunity to capitalize.‍

Risks of an ARM

While the benefits are excellent, adjustable-rate mortgages also carry many risks. The selling point of an ARM is that the interest rate fluctuates. A fluctuating rate means that the borrower must prepare to have higher payments at the end of every period. If interest rates increase, so will the payment. ‍

When rates go up significantly, it is referred to as payment shock. It might cause unprepared homeowners financial stress. Rate changes also add an element of uncertainty, which may lead to budget problems. If interest rates rise, it may be difficult to obtain a refinance for your ARM. This is problematic for those who wish to switch to a fixed-rate mortgage.‍

ARM vs. Fixed Rate Mortgage

Adjustable and fixed-rate mortgages are two conventional home loan programs. They are distinct in that the interest rate changes over time. ‍

ARMs have an interest rate that adjusts after the fixed-rate period. Fixed-rate loans will never change interest rates unless refinanced. ARM often offers lower initial rates, while fixed-rate will offer a more stable and predictable payment plan. Fixed-rate loans are the default loan type, with homebuyers seeking out ARM loans in specific situations.‍

Types of ARM Loans

There are seven major ARM loan types. They follow the same basic principles. However, they are repaid at different speeds or with varied interest periods.‍

• Hybrid ARMs: These mortgages begin with a fixed-rate period, which can vary from three to ten years. After this, the rate is adjusted according to an index and the lender’s margin.
• 3/1 ARM: this ARM has a fixed rate for three years and is adjusted annually for the rest of the loan life.
• 5/1 ARM: like the 3/1, except the fixed rate lasts for five years before the annual adjustments begin.
• 7/1 ARM: same as the above loans, except with a seven-year fixed rate.
• 10/1 ARM: same as the above, but with a 10-year fixed rate.
• 5/5 ARM: This loan has a five-year fixed rate and then will be adjusted every five years after the end of the first period.
• Interest-only ARM: This ARM allows the homebuyer to make payments only on interest for the first 5 to 10 years, after which it becomes a standard ARM.

How to Qualify for an ARM

Lenders look for high credit scores, stable income, low DTI, and stable financial history. With an ARM, lenders may also require proof of cash reserves to demonstrate the homeowner can handle a payment increase if one occurs.‍

Understanding ARM Interest Rates

The world of ARM loans may be confusing. To understand how ARM interest rates work, 4 issues need to be explained: caps, indexes, reset periods, and prepayment penalties. ‍

ARM Caps

ARM caps set boundaries for how high the adjusted rate can climb. If the cap is 1%, then no matter how high the index rises, the ARM interest rate cannot adjust more than 1% per period.‍

ARM Indexes

Every ARM uses an index to determine how the rates must be adjusted. If the index rises, so will the ARM interest. Typical indexes include the London Interbank Offered Rate (LIBOR), the Constant Maturity Treasury (CMT) rate, or the Cost of Funds Index (COFI). ‍

ARM Reset Periods

ARM reset periods refer to the loan adjustment periods. If the interest rate adjusts every 3 years, the ARM has a 3-year reset period.‍

ARM Payment Calculators

ARM payment calculators are online tools for predicting ARM loan payments. Click here to try ours!

Summary

ARM loans are a viable alternative to fixed-rate loans in certain situations. They have many risks and benefits, all of which need to be considered. Caps, indexes, and reset periods help understand the interest rates for a particular ARM. To learn more about adjustable-rate mortgages, contact a representative at Wesley Mortgage, the official mortgage provider of the Tennessee Titans, at the link below!