What Is an Adjustable-Rate Mortgage?

Starting a new life chapter often comes with big decisions and a lot of paperwork. One of the most important choices you’ll have to make is what kind of home loan you want. Whether you’re a first-time home buyer or looking to refinance, there are many loan options available. But one type of loan that may stand out to you is an adjustable-rate mortgage, or ARM.

So what is an adjustable-rate mortgage?

An adjustable-rate mortgage (ARM) is a loan where the interest rate changes based on market conditions.

For an ARM, the interest rate isn’t fixed. It adjusts periodically. This means your monthly payment could go up or down depending on economic conditions.

But that’s not all. You need to understand how ARMs work before you decide if one is right for you. Let’s take a closer look!

How Does an Adjustable-Rate Mortgage Work?

ARMs are one of the most common variable-rate loans – meaning the interest rate can fluctuate based on economic conditions – available to home buyers today.

With an ARM, you’ll have a low introductory interest rate for a set period, usually 3, 5, 7 or 10 years.^[1] After that, your interest rate will adjust based on an index plus a margin.

The index is a benchmark interest rate that reflects general market conditions. The margin is a set percentage point added to the index, which your lender determines. The index and margin are added together to form your interest rate, which can adjust up or down, depending on the index.

For example, let’s say the index is 2.5%, and the margin is 2.75%. The interest rate on your ARM loan would be 5.25%.

Most ARMs are adjustable based on the London Interbank Offered Rate (LIBOR), a benchmark rate set by banks in London. The LIBOR is used as a base rate for adjustable-rate mortgages, car loans and other types of loans. The LIBOR is based on the rates at which banks lend money to each other in the London interbank market. 

Adjustable-rate vs. fixed-rate mortgages 

On a fixed-rate mortgage, the interest rate stays the same for the loan’s entire life.

With an adjustable-rate mortgage, the interest rate can change over time. The monthly payment on an ARM loan can increase or decrease depending on market conditions. Most ARM loans have a fixed interest rate for a time, and then the interest rate adjusts periodically.

One of the major attractions of fixed-rate mortgages is the predictability of monthly payments. You know exactly how much you’ll be paying each month in principal and interest, and you don’t have to worry about your payment going up or down.

With an adjustable-rate mortgage, on the other hand, your monthly payments can change after the introductory period. If market conditions cause the index to go up, your interest rate and monthly payments will also increase.

The benefit of an ARM is that you can get a lower interest rate than you would on a fixed-rate mortgage during the initial period. You can also save money on your monthly payments after the initial period if market conditions are favorable. If you get to a point where you have to pay more per month, and decide you want the security of a fixed loan, you can refinance your adjustable-rate mortgage to a fixed-rate mortgage.

The fixed-rate period

Teasers don’t last forever, and that’s especially true for teaser rates on adjustable-rate mortgages. The initial fixed-rate period of an adjustable-rate mortgage generally lasts 3, 5, 7 or 10 years,^[1] after which your interest rate will be subject to change . 

For example, let’s say you have a 5/1 ARM. That means your interest rate will be fixed for five years, which can adjust once per year.

Your interest rate will be based on an index plus a margin. The index is usually the LIBOR, the rate banks charge each other for loans. The margin is a set percentage rate the lender adds to the index and it’s usually 2% – 3%.^[2] So if the LIBOR is 1.5% and your margin is 2.5%, your interest rate will be 4%.

This may all sound like a lot of math, but it’s actually pretty simple. The index plus the margin equals your interest rate.

Interest rate caps

Your interest rate can only adjust so much, even if the index goes up or down. This is called a periodic rate cap. Lenders typically set a periodic rate cap of 2% or 5%,^[3] meaning your interest rate can only go up or down 2% or 5% each time it adjusts. Some lenders also set an interest rate floor, which is the lowest your interest rate can go.

It’s important to understand that your interest rate isn’t the only thing that can change when you have an adjustable-rate mortgage. Your monthly payments will also go up or down, depending on how your interest rate adjusts.

To protect yourself from huge monthly payment increases, you can ask for a payment cap – also called a periodic payment cap. This limits the amount your monthly payment can increase to, even if your interest rate goes up.

You may also have a lifetime payment cap. This is the highest your monthly payment can go, no matter how high your interest rate gets. Lifetime payment caps indicate the maximum interest rate a borrower can pay over the life of the loan.

These caps protect you from huge interest rate increases, helping to keep your monthly payments affordable.

How Are ARM Interest Rates Determined? 

Your ARM interest rate is determined by a number of factors, including the lender you choose, the type of mortgage you get and the economy.

Usually, when the 10-year US Treasury note yield goes up, ARM rates go up. That’s because they’re both based on long-term interest rates.

Interest rates also tend to increase when the economy is doing well, as the demand for loans is higher when the economy is strong. When demand is high, rates go up.

The type of mortgage you have can also influence your interest rate. For example, 5/1 ARMs usually have lower rates than 7/1 or 10/1 ARMs because they have a shorter fixed-rate period. And adjustable-rate jumbo loans typically have higher rates than adjustable-rate conforming loans. 

What Are the Types of Adjustable-Rate Mortgages? 

When people think of adjustable-rate mortgages, they think of 5/1 ARMs. While the 5/1 ARM is the most common type of adjustable-rate mortgage, there are other types of ARMs available.

Depending on your home-buying goals, one kind ofARM might be a better fit for you compared to another. 

5-year ARMs

The 5/1 ARM is the most common type of 5-year adjustable-rate mortgage. Its interest rate is fixed for 5 years. After those 5 years are up, your interest rate can go up or down each year, depending on market conditions. 

With a 5/6 ARM, on the other hand, your interest rate is fixed for 5 years. It’s then allowed to adjust once every 6 months after the initial 5-year period.

7-year ARMs

Some ARMs allow the homeowner to pay a fixed rate for 7 years before the interest rate adjusts. The 7/1 ARM and 7/6 ARM are two common types of 7-year ARMs. The 7/6 ARM is like the 7/1 ARM, but it adjusts every 6 months. 

10-year ARMs

A 10-year ARM is another option for borrowers. This ARM offers a lower interest rate for the first 10 years of the loan. But after that, it can adjust annually. If you’re keen on making fixed monthly payments for 10 years before your interest rate adjusts, a 10-year ARM – specifically the 10/1 ARMs – could be a good option for you. 

What is a hybrid ARM?

True to its name, a hybrid ARM is a mix between a fixed-rate mortgage and an adjustable-rate mortgage. Borrowers may find a hybrid ARM appealing because it offers the stability of monthly payments for a certain period.

For instance, a 5/1 ARM and 7/1 ARM are the most popular, since the monthly payments are fixed for 5 years and 7 years (respectively) until the reset date.

After the initial introductory period expires, the interest rate on the loan resets and becomes variable for the remaining life of the loan, with a potential to increase or decrease, depending on market conditions. 

What is an interest-only ARM?

An interest-only ARM is a mortgage in which the borrower pays only the interest for a certain period. You still have to pay back the principal amount of the loan, but for a specific period, you’ll only be required to pay the interest.

Interest-only ARMs are appealing because they usually have lower monthly payments than other ARMs, as the borrower only pays the interest, not the principal. 

What are payment-option ARMs?

A payment-option ARM is a type of mortgage that gives borrowers more flexibility when it comes to making monthly payments

With a payment-option ARM, borrowers can choose to make one of four different types of monthly payments:

• A minimum payment that covers only the interest on the loan
• A full payment that covers both the principal and the interest
• A minimum payment that covers only a portion of the interest, with the rest deferred to be added to the loan’s principal balance
• An “interest only” payment that covers only the interest on the loan

The minimum payment option is the most popular among borrowers, allowing them to make very low monthly payments. Plus, the interest that’s deferred is usually tax-deductible.

However, this option can end up costing borrowers more in the long run, as the deferred interest is added to the loan’s principal balance, resulting in a higher total loan amount.

What are conforming and nonconforming ARMs?

A conforming ARM is a mortgage loan that falls within the guidelines set by government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.

Fannie Mae and Freddie Mac are GSEs that purchase mortgages from lenders. The guidelines set by Fannie Mae and Freddie Mac are meant to ensure the loans they purchase are of a certain quality.

Conforming loans must have certain features – such as a maximum loan amount, a maximum loan-to-value ratio and a minimum credit score – which ensure the loans are affordable and have a lower risk of default.

On the other hand, nonconforming or jumbo loans don’t meet the guidelines set by Fannie Mae and Freddie Mac. Nonconforming loans may have a higher risk of default. But they can also offer borrowers more flexibility, such as a higher loan amount or a lower down payment. 

How To Qualify for an Adjustable-Rate Mortgage 

Your journey toward homeownership starts with getting pre-qualified for a mortgage. This gives you an idea of how much you can borrow and what kind of interest rate to expect.

To get pre-qualified, lenders will review your financial background for a better understanding of your ability to borrow a home loan.

They’ll look at factors like your income, debt-to-income (DTI) ratio, employment history and credit score. These checks are instrumental in helping lenders determine whether you truly qualify for a home loan.

Pros and Cons of an Adjustable-Rate Mortgage

Are you considering an adjustable-rate mortgage? Check out the pros and cons first.

Adjustable Rates and a Flexible Future

Your home-buying journey is unique, as is your financial situation. 

An adjustable-rate mortgage could give you the flexibility to find the right home while keeping your payments manageable.

Of course, there’s always the risk that your payments could go up in the future. But if you’re prepared for that possibility and comfortable with the risks, an ARM could be a good option.