What is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage, also known as ARM, is a type of home loan in which the interest rate continues to adjust throughout the life of the loan. With an ARM, the introductory interest rate is fixed for a period of time, anywhere from 3 to 10 years. After this initial period of time, the interest rates will periodically go either higher or lower. This change can occur yearly or even monthly.
Adjustable-rate mortgages are also called variable-rate mortgages or floating mortgages. The interest rate for an adjustable-rate mortgage is reset based on a benchmark or index, plus an additional spread called an ARM margin.
How Does an Adjustable-Rate Mortgage Work?
To understand how an ARM loan works, it’s important to first understand a few terms:
Index: An index is used to determine the cost of variable-rate mortgages. The index rate can increase or decrease at any time.
Margin: The margin is a percentage point that is determined in advance by your lender. It remains the same throughout the life of your loan. It is used to determine the interest rate for loans.
Initial Cap: This is the maximum amount the interest rate can adjust the first time it changes after the fixed period of time.
Periodic Cap: This refers to the maximum interest rate adjustment allowed during a particular period of an adjustable rate mortgage.
Lifetime Cap: This puts a limit on the interest rate increases during the life of the loan. All ARM’s have a lifetime cap.
Adjustable-rate mortgage interest rates increase or decrease based on an index plus a set margin at the close of the fixed-rate period. Generally, mortgages are tied to one of the three different types of indexes:
- The maturity yield on one-year Treasury bills
- 11th District cost of funds index (COFI)
- London Interbank Offered Rate (Libor) – this will be phased out by the end of 2021
The margin stays the same although the index rate can change.
Is an Adjustable-Rate Mortgage Right for You?
There is the right mortgage product out there for every borrower. For some, that product is an adjustable-rate mortgage. For instance, if you’re a first-time home buyer and you don’t intend to make this home your “forever” home, then choosing an ARM rather than a fixed-rate loan can yield large cash savings.
This would also apply to buyers who move frequently. It doesn’t make much sense to pay for a 30-year rate if you are going to move in 5 or 6 years.