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Adjustable-Rate Mortgage: A Definition

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Published on March 6, 2020
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No two home buyers are the same. People come from different backgrounds, have different financial goals and different plans for the future. Luckily, lenders don’t try a one-size-fits-all approach when it comes to mortgages. Instead, they offer different loan options to better fit a buyer’s own personal needs. For example, the fixed-rate loan may be good for those who want to plant their roots and have the reliability of an interest rate that never changes. But for those who are purchasing a starter home or have a lifestyle that involves constant moving, an adjustable rate mortgage may better meet their needs. Read on to learn more about adjustable rate mortgages to determine if this loan option will fit into your lifestyle and best help you reach your financial goals.

What Is An Adjustable Rate Mortgage?

As the name suggests, an adjustable rate mortgage is a home loan with an interest rate that adjusts over time based on market conditions. This type of mortgage comes with a 30-year term. The initial rate stays fixed for a specified number of years at the beginning of the loan term before it adjusts for the remainder.

How Does An ARM Loan Work?

To comprehend the functionality of ARMs, there are a few terms to understand.

Index: This is an economic indicator used to calculate interest rate adjustments for ARMs. The index rate can increase or decrease at any time. As of this writing, the two most commonly used indexes are the London Interbank Offered Rate for conventional loans and the Constant Maturity Treasury for loans backed by the U.S. government.

Margin: This is a percentage point predetermined by your lender that remains the same throughout the life of the loan. It’s used to determine the interest rate for loans.

Once the initial fixed-rate term ends on an ARM, the interest rate typically adjusts annually. This new rate is determined by adding the index to the margin. While this may cause the interest rate to increase, there are caps on how much it can increase.

Initial cap: This cap is the maximum amount the interest rate can adjust the first time it’s changed after the fixed period.

Periodic cap: This cap puts a limit on the interest rate increase from one adjustment period to the next. The initial cap and the periodic cap may be the same or different.

Lifetime cap: This cap puts a limit on the interest rate increase over the life of the loan. All adjustable rate mortgages have a lifetime.

These limits are put in place for rate increases. It’s important to note that interest rates can decrease, too, and there are no minimum limits on that. However, since the margin stays the same throughout the life of the loan and is added to the index to get the interest rate, the rate will never fall below the margin.

Cap structure: A numerical representation of each cap for the loan. This is presented in a series of three numbers that represent the three caps: initial cap/periodic cap/lifetime cap.

Here’s an example of a common rate cap: (2/2/5). This means that your interest rate can only change by up to 2% the first time it adjusts. Each annual rate change after that is limited to 2% each year. Throughout the rest of the loan term, the highest the interest rate can go is 5% higher than the fixed rate. So, if your original rate was 3.5%, your interest rate can only go up to 8.5% during the life of your loan.

Different Types Of ARMs

Numerical form is also used for the different types of ARMs. This structure is presented with two numbers. The first number is how long your fixed-rate period will last. The second number is how often the rate will change every year. Here are the most common ARMs:

5/1 ARM

A 5/1 ARM has a fixed rate of interest for the first 5 years of the loan. After that, the interest rate will adjust once annually over the remaining 25 years.

7/1 ARM

A 7/1 ARM has a fixed rate of interest for the first 7 years of the loan. After that, the interest rate will adjust once annually over the remaining 23 years.

10/1 ARM

A 10/1 ARM has a fixed rate of interest for the first 10 years of the loan. After that, the interest rate will adjust once annually over the remaining 20 years.

Other Types Of ARMs

As long as lenders meet federal lending laws, they have some flexibility with how they structure their ARMs. Therefore, there can be a number of different ARMs, including a 3/1 ARM, which has a fixed-rate term of 3 years. There are also some lenders that offer a 1-year ARM, which has a fixed-rate term of just 1 year.

Choosing The Right ARM

With all of these different types of ARMs, how do you know which one to choose? Here are a few things to consider:

  • How long do you plan to stay in your home?
  • Do you expect any big life events in the next 5 – 10 years (marriage, children, new job)?
  • Do you need time to comfortably afford a bigger monthly payment? How much time?
  • Is your income unstable or going to be unpredictable in the next few years?
  • What adjustable rate mortgage optionsdoes your lender offer?

If you plan on living in your home for less than 10 years, a 5/1 or 7/1 ARM may be a good option for you. If you plan on living in the home long-term or need extra time to create a firm financial footing, a 10/1 maybe be a better choice. When deciding which ARM is right for you, discuss these things with your home loan expert, who can make recommendations based on your individual goals and needs.

ARM Vs. Fixed-Rate Mortgage

As their names imply, one of the biggest differences between ARMs and fixed-rate mortgages is that one has an interest rate that changes and one has an interest rate that stays the same throughout the life of the loan. While an ARM does have a fixed interest rate for a certain amount of time in the beginning, it eventually goes up or down throughout the loan term. A fixed-rate loan has the same interest rate from start to finish. Here are a few other differences between an ARM and a fixed-rate mortgage.

  • Fixed-rate loans are most commonly offered as 15- or 30-year terms or custom-term loans. ARMs are typically 30-year terms.
  • Your starting rate may be lower for an ARM than a fixed-rate mortgage.
  • Your monthly mortgage payment may be more affordable in the first few years of an ARM.

The minimum down payment for an ARM is 5%. The minimum down payment for a fixed-rate mortgage can be as low as 3%, depending on the loan.

Like any loan, ARMs come with advantages as well as certain considerations to bear in mind.

Advantages

The biggest advantage of an ARM is the initial fixed-rate term, which, as mentioned above, can provide you a lower initial rate and monthly payment than other loans. Here are a few other benefits:

  • If you plan to move or sell your house within a few years, you can reap the benefits of a low fixed rate and sell the home before it adjusts.
  • Remember, interest rates can go up and if mortgage interest rates fall, you could get an even lower monthly payment than you had before.
  • If rates do fall, you’ll be able to reap the benefits without having to go through the costs or paperwork of a refinance.

Considerations

When deciding whether to get an ARM, mull over these other factors:

  • You may plan to move or sell your home within a few years, but things happen. You may not be able to sell the home when you want or some life event could keep you from moving than originally planned.
  • While your interest rate could go down, it could also rise. If your interest rate increases, you’ll have a higher monthly payment, one you may not be prepared for.
  • Some ARMs may have a prepayment penalty. Speak to your lender and make sure you understand the terms of the loan before you move forward (Quicken Loans® does not have any prepayment penalties).

Is An ARM Loan Right For You?

Now that you know what an ARM is and how it works, you’ll be able to better determine whether it’s the right loan option for you. Before deciding, answer some of these questions:

What’s The Current Interest Rate Environment?

It can make more sense to get an ARM when interest rates are on the rise, as long as you plan on moving before your rate adjusts. The reason for this is when interest rates are rising, there tends to be a more pronounced difference between fixed and adjustable rates. The rate during the initial fixed period for an ARM loan will be much lower compared to a fixed rate at this time than it would be if fixed rates were lower.

Can You Take Advantage Of The Fixed Rate Period?

If you’re able to make extra mortgage payments toward the principal balance during the fixed, low-rate period of your ARM, you could pay down more of your principal balance. This could save you more money on interest in the long run, which could keep payments low when your interest rate does adjust.

How Long Do You Plan To Live In The Home?

An adjustable rate mortgage is an excellent option for those buying a starter home who plan on moving into a bigger house within the next 5 years. Or, if you relocate fairly frequently, committing to a 30-year fixed-rate mortgage won’t grant you the same flexibility as an adjustable rate mortgage. With an ARM, you could take advantage of the low rate today with the knowledge that you’ll be moving before it adjusts to a different interest rate.

For both first-time home buyers and savvy refinancers, if interest rates continue to rise as predicted through the new year, then an ARM could make more financial sense than a fixed-rate mortgage for your home loan. Keep in mind that there’s risk involved and make sure you consider your options. If you plan on staying in the home long term, make sure you’re able to handle the financial changes that may come if your rate increases.

Whether you’re interested in an ARM or a fixed-rate loan, you can get started with your mortgage approval online.

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The initial payment on a 30-year $200,000 5-year Adjustable-Rate Loan at 3.75% and 74.91% loan-to-value (LTV) is $926.24 with 3.375 points due at closing. The Annual Percentage Rate (APR) is 4.456%. After the initial 5 years, the principal and interest payment is $975.97. The fully indexed rate of 4.25% is in effect for the remaining 25 years and can change once every year for the remaining life of the loan. Payment does not include taxes and insurance premiums. The actual payment amount will be greater. Rate is variable and subject to change after 5 years. The rate is current as of November 8, 2019.