An “adjustable-rate mortgage” is a loan program with a variable interest rate that can change throughout the life of the loan. It differs from a fixed-rate mortgage, as the rate may move both up or down depending on the direction of the index it is associated with.
All adjustable-rate mortgage programs come with a pre-set margin that does not change, and are tied to a major mortgage index such as the Libor, COFI, or MTA. Some banks and mortgage lenders will allow you to choose an index, while many rely on just one of the major indices for the majority of their loan products.
How an Adjustable-Rate Mortgage Works
- Initial rate: 5.25%
- Margin: 2.25 (won’t change)
- Index: 4.75 (can go up and down)
- Caps: 6/2/6
Typically, an adjustable-rate mortgage will offer an initial rate, or teaser rate, for a certain period of time, whether it’s the first year, three years, five years, or longer. After that initial period ends, the ARM will adjust to its fully-indexed rate, which is the margin plus index.
To figure out what your fully-indexed interest rate will be each month with an adjustable-rate mortgage, simply add the margin to the associated index. You’ll be able to look up the current index price on the web or in the newspaper, and the margin you agreed to, which is usually found within your loan documents. You’ll also have to factor in payment caps to see when and how often your adjustable-rate mortgage actually adjusts.
Based on the two figures above, your fully-indexed rate would be 7.00%. It is equally important to note both the index and margin when selecting a mortgage program from your bank or mortgage broker. Many consumers overlook the margin, or simply don’t even realize it’s an active component of the adjustable-rate mortgage.
But as you can see, it plays a major role in the pricing of an ARM. Margins can vary by over 1% from lender to lender, so it can certainly affect you mortgage payment in a major way.
Adjustable-Rate Mortgage Interest Rate Caps
Adjustable-rate mortgages also carry adjustment caps, which limit the amount of rate change that can occur in certain time periods. There are three types of caps to take note of:
Initial: The amount the rate can change at the time of the first adjustment. In the examples above, it would be the initial change after the first 5 years of the loan.
Periodic: The amount the rate can change during each period, which in this case of a 5/6 ARM is every six months, or just once a year for a 5/1 ARM.
Lifetime: The amount the rate can change during the life of loan. So throughout the full 30 years, it can’t exceed this amount, or drop below this amount.
Typically, you might see caps structured like 6/2/6. This means the rate can change a full 6% once it initially becomes an adjustable-rate mortgage, or 2% periodically, and 6% total throughout the life of the loan. And remember, the caps allow the interest rate to go both up and down. So if the market is improving, your adjustable-rate mortgage can go down!
However, many lenders put in interest rate floors that often coincide with the initial rate, meaning your rate will never go below its start rate.
Hybrid Adjustable-Rate Mortgages
Nowadays, most adjustable-rate home loans are hybrids, meaning they carry an initial fixed period followed by an adjustable period. They are also usually based on a 30-year amortization, meaning they last 30 years like fixed mortgages and are paid off similarly.
For example, you may see mortgage programs advertised like a 5/25 ARM or 3/27 ARM, just to name a couple. A 5/25 ARM means it is a 30-year mortgage, with the first five years fixed, and the remaining 25 years adjustable. Same goes for the 3/27, except only the first three years are fixed, and the remaining 27 years are adjustable.
You may also see programs such as a 5/6 ARM, which means the interest rate is fixed for the first five years, variable for the remaining 25 years, and will adjust every six months. If you see a 5/1 ARM, it is exactly the same as the 5/6 ARM, except it changes only once a year after the five-year fixed period.
Types of Adjustable-Rate Mortgages
There are many different types of adjustable-rate mortgages, ranging from one-month ARMs to 10-year ARMs. Obviously this represents quite a range of risk, so be careful when comparing different loan products.
- 1-year ARM: First adjustment after one year, then adjusts annually
- 3/1 ARM: First adjustment after three years, then adjusts annually
- 5/1 ARM: First adjustment after five years, then adjusts annually
- 5/5 ARM: First adjustment after five years, then adjusts every five years
- 5/6 ARM: First adjustment after five years, then adjusts every six months
- 7/1 ARM: First adjustment after seven years, then adjusts annually
- 10/1 ARM: First adjustment after 10 years, then adjusts annually
As you can see, an ARM can give you as long as 10 years of fixed-rate payments, or as little as one month.
Note that there are other types of ARMs out there, and they may be advertised differently. For example, you might see a 2/28 ARM, or a 3/27 ARM, which are fixed for two and three years, respectively, before becoming adjustable.
Why Choose an Adjustable-Rate Mortgage?
Most homeowners get into adjustable-rate mortgages for the lower initial payment, and then usually refinance the loan when the fixed period ends. At that time, the interest rate becomes variable, or adjustable, and the homeowner would likely refinance into another ARM, something fixed, or sell the home outright.
Some homeowners may also choose an adjustable-rate mortgage if the home is simply a short-term investment, or if they don’t plan on owning the home for more than five years.
For the record, a home equity line of credit (HELOC) is also considered an adjustable-rate mortgage because it’s tied to prime, and that can change whenever the federal funds rate changes.
But keep in mind that all adjustable-rate mortgages carry risk as the monthly payments can change, sometimes sharply if the timing isn’t right.
All that said, make an interest rate plan before you purchase a property. Decide what you want to do with the home in the next five years, and from there, you’ll be able to decide if an adjustable-rate mortgage is right for you.