Jul 27, 2022
How do adjustable rate mortgages (ARMs) work?
Adjustable rate mortgages have not been popular recently because the spread between the ARM and the fixed rate has been very small. If the fixed rate is at 4.5% and the ARM is at 4.25%, nobody’s getting an ARM. But we’re starting to see that change. With the overall increase in mortgage interest rates, ARMs are having a bit of a renaissance.
They’re not for everyone. But if you are a financially savvy borrower and you understand their mechanics, in the right market, an ARM can be a beautiful tool. Here’s how they work:
Most ARMs have initial fixed rate periods called start rates. These start rates usually range from seven to ten years. The first number in the product description indicates the length of time the start rate applies. A 7/1 ARM has an initial start rate of seven years. A 10/1 ARM has a start rate that lasts ten years. In theory, the longer the fixed rate period, the higher the start rate. So a 7/1 ARM should have a lower start rate than a 10/1 ARM (although it doesn’t always work that way).
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 SOFR and the CMT. After the start rate period expires, the original margin is added to the current value of the index to determine the new interest rate.
The second number in an ARM product description determines how often the interest rate adjusts after the start rate period is finished. So a 7/1 ARM adjusts every year. And a 7/6 ARM adjusts every six months.
Adjustable rate mortgages 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.
Let's look at an example of an ARM:
7/1 SOFR ARM 5/2/5 and 2.25%
The first two numbers refer to the initial fixed rate period (seven years) and the adjustment period afterwards (every year). The SOFR refers to the index. And the last number (2.25%) is the margin. Thus, if the value of the SOFR index is 2.0 in seven years, the interest rate would adjust to 4.25% (index plus margin).
The middle set of numbers refers to the interest rate adjustment caps. The first time the interest rate adjusts, it can't increase more than 5% over the start 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 start 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 keeping their mortgage for 30 years. A consumer who plans to move in the first several years or is comfortable refinancing, may find that an ARM saves quite a bit on interest charges during the first years of their home loan.
- 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).