What is an Adjustable-Rate Mortgage (ARM)?

What is an Adjustable-Rate Mortgage (ARM)

An adjustable-rate mortgage (ARM) or variable rate mortgage as they are typically known is a type of financing provided to homebuyers looking to secure a property over the usual time frame of 30 years. The key to an adjustable-rate mortgage is that the rate remains steady for an agreed upon time frame then rises incrementally over the balance of the loan.

The rates for an adjustable-rate mortgage are aligned with an index known as a LIBOR. Rates that fall under this benchmark are determined via the rate that banks loan money to other financial institutions. As the current LIBOR rate stands at 0.07%, the initial rate for an ARM approved today would be based around this percentage standard.

How Does An Adjustable Rate Mortgage Work?

When it comes to a typical mortgage the loan usually lasts over a thirty year term. However, with an adjustable-rate mortgage, borrowers tend to prefer to pay them off within a shorter period such as 5 or 10 years due to the ballooning interest payments. In the first few years of the mortgage, the rate stays the same regardless of how long that time frame lasts.

Once the arm adjusts on the loan then you will be required to pay the higher rate for the remaining balance over the course of the next several years or decades. With an ARM or adjustable-rate mortgage, you will typically be offered a much lower annual percentage rate than a standard home loan, due to the fact that you will be required to cover the adjusted rate until the loan term is completed.

Different Types of Adjustable Rate Mortgages

There are a few different types of mortgages that come with the option of having an adjustable rate. These are interest only loans, payment option loans, and hybrid loans. Adjustable-rate mortgages are then divided into subcategories to reflect the offerings of each in terms of years.

Interest Only Loans

Interest only loans are those which allow the borrower to pay the interest for the majority of the mortgage versus the principal amount. Once the interest only period is over then you would revert to paying the principal in addition to the interest over monthly payments. These types of loans are geared towards homeowners who prefer to make smaller payments upfront versus an enlarged payment.

Payment Option Loans

Adjustable-rate mortgages with a payment option provide you with the ability to choose from a variety of payment structures. Some of the most common designations are a smaller principal amount, electing to pay only the interest, or another prearranged amount. For borrowers who elect to use this loan option, the caveat is that the entire loan will have to be repaid over time which may increase the interest owed.

Hybrid Loans 

Hybrid adjustable-rate mortgages or ARMS offer you a loan that will contain a period of fixed rate payments as well as adjustable rate payments. For a standard hybrid loan,you will be paying a basic interest rate then the rate will steadily increase over time. An example of a hybrid loan (10/1) would be a ten year loan with a fixed rate, that converts to a constantly changing variable rate every year going forward.

Adjustable Rate Mortgage Terms 

The adjustable rates on a mortgage are written in terms that demonstrate how many years that you will be paying the same interest rate, followed by how often the rate will flip or adjust over a set amount of time.

Below are the most widely initiated ARMs: 

  • 5/1 Adjustable-Rate Mortgage – The 5/1 ARM provides you with a stable interest rate over the initial 5 years and adjusts each year for the next 25 years of the loan.
  • 5/6 Adjustable-Rate Mortgage –The 5/6 ARM provides you with a steady interest rate over the initial 5 years and adjusts semi-annually for the next 25 years of the loan.
  • 10/1 Adjustable-Rate Mortgage –The 10/1 ARM provides you with a fixed term interest rate over ten years and adjusts each year for the next 20 years of the loan.
  • 7/6 Adjustable-Rate Mortgage – The 7/6 ARM provides you with a set interest rate over the initial 5 years and adjusts in six month intervals over the next 25 years of the loan.
  • 10/6 Adjustable-Rate Mortgage –The 5/1 ARM provides you with a guaranteed interest rate over the initial 5 years and then adjusts twice annually for the next 25 years of the loan.

How is a Variable Rate on An ARM Determined?

Variable rates on an ARM tie into the ARM margin index which is based on the rates that banks loan money to other banks or the LIBOR standard. The margins are percentage or basis points set by your mortgage lender at the time of your loan origination. As the rates change and adjust they are essentially capped on the amount of increase that can occur. These caps are known as initial (first adjustment), periodic (subsequent adjustment), and ceiling (maximum allowable increase overall).

There are also other factors to consider when determining the price such as the Secured Overnight Financing Rate or Treasury Index, which define the costs associated with overnight cash loans between financial institutions and heavily influence the mortgage interest rates.

Adjustable Rates vs. Fixed Rates 

Adjustable-rate mortgages offer borrowers the chance to enter into a mortgage contract with an extremely low interest rate. Traditional mortgages, on the other hand, require you to put down a higher rate which stays consecutive throughout the loan. While fixed rate mortgages remain stable and aren’t subject to market whims, adjustable rates have fluctuations based on economic factors. 

Adjustable-Rate MortgageFixed Rate Mortgage
Paid over 30 year terms with early payoff optionPaid over a fix term of 15 or 30 years
Rates adjust swiftly at irregular intervalsRates remain steady over the course of the loan
Lower teaser rates for introductory periodHigher rates for entirety of the mortgage
Down payments as low as 5 percentRequire down payments of 3 percent or more

Is an Adjustable Rate Mortgage Right for You?

Adjustable-rate mortgages were first introduced around forty years ago in order to give prospective buyers the right to afford a home that was based on their budgets and offered flexible payment terms. If you are looking to purchase a home and don’t have a large sum of money for a down payment, or prefer the ability to pay lower monthly installments then you may consider applying for an adjustable rate mortgage.

However, if you have a fluctuating income or aren’t fully sure that you can handle the large adjustment in payments after the introductory period then you may want to reconsider the type of mortgage that you are seeking approval for.

Conclusion

Buying a home is a large financial decision and having adequate tools at your disposal can assist you in determining if an adjustable-rate mortgage will fit into your financial picture. By examining the interest rates, payment amounts, and other conditions you will be equipped to make the right decision for your family.

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