Aug 2, 2017

How do adjustable rate mortgages (ARMs) work?

Definition of ARM Terms

Most ARMs have initial fixed rate periods of three to ten years.  The longer the fixed rate period, the higher the initial interest rate.  A 5/1 ARM, for instance, will have a lower initial interest rate than a 10/1 ARM.

Adjustable rate mortgages are also assigned a margin and an index.  A margin is a fixed number that never changes over the life of the loan.  An index fluctuates based on market conditions.  Common ARM indices include the LIBOR or the CMT.

After the initial fixed rate period expires, the original margin is added to the current value of the index to determine the new interest rate.  Adjustable rate mortgages also have limits on how much the interest rate can change at each adjustment period as well as a lifetime limit, an interest rate that it can't exceed regardless of the value of the index.

In the graphic above, the 5/1 ARM has an initial fixed rate period of five years.  After that, the interest rate will adjust every year.  The margin is 2.25% and the index is the LIBOR.  Thus, if the value of the LIBOR index is 2.5% in five years, the interest rate would adjust to 4.75%.

The first time the interest rate adjusts (after the initial five year fixed rate period), the interest rate can't increase more than 5% over the initial interest rate.  At each subsequent adjustment, it can't increase more than 2% above the previous year's interest rate.  And the maximum interest rate for the life of the loan is 5% above the initial fixed interest rate.

Advantages of an Adjustable Rate Mortgage

  • When interest rates change, the new monthly payment is based on the current balance, not the original loan amount.  Consequently, extra principal payments may be used to decrease monthly payments (instead of decreasing the term of the loan).
  • An ARM is an excellent choice for someone who doesn't plan on living in their home for 30 years.  Adjustable rates can save thousands the first three to ten years.
  • An individual who may not qualify for a fixed rate mortgage payment may find an ARM is just the tool they need to qualify for a slightly larger home.
  • Recent college graduates or new business owners may enjoy ARMs because they anticipate their income increasing in the coming years.

For more information, check out the government's Consumer Handbook on Adjustable Rate Mortgages (it's actually pretty handy).