An adjustable rate mortgage (ARM) has an interest rate that fluctuates periodically. This is in contrast to a fixed rate mortgage, which always has the same interest rate.
Every ARM has basic components:
- An index
- A margin
- An adjustment period
- An interest rate cap
- A rate floor
- An initial interest rate
An ARM’s interest rate is tied to one of many economic indices set up by the Federal Reserve. It can be tied to the 1 year US Treasury Index, or the 3 year US Treasury Index. It can be tied to the Prime Rate. The value of each of these indexes fluctuates. Different indices move at different rates so know the name and characteristics of the index used for your ARM.
The interest rate for your ARM will be calculated by adding a margin to the interest rate from the index. The margin is basically the markup charged by the lender that allows them to make a profit off of your loan, such as adding 2% to the index, where the 2% is the margin. The margin of your loan usually does not fluctuate.
The Adjustment Period
The Adjustment Period controls when and how often your interest rate changes. For example, if your ARM has an adjustment period of 1 year, your interest rate will be subject to change at the end of each year and your monthly mortgage payment will be recalculated to reflect this change. ARMs can have more than one adjustment period attached, for example, a 7-3 ARM will adjust, for the first time, after 7 years, and again once every three years after that.
The Interest Rate Cap
Interest rate caps are built into the loan to protect the borrower from drastic interest rate fluctuations. The caps limit how much the interest rate or monthly payment can change at the end of each adjustment period. An ARM can also have a cap for the life of the loan. For example, during the life of a loan, the interest rate can only be increased by 5%.
The Interest Rate Floor
This is the lowest rate your ARM can go to. Some of them won't go below the initial interest rate you pay, others will fluctuate lower based on the index.
The Initial Interest Rate
The Initial Interest Rate is the interest rate that you start with at the beginning of your loan period. The initial interest rate for an adjustable rate mortgage is usually lower than the current prevailing rates for a fixed rate mortgage. The length of time your loan stays at this rate is built into the loan, ex. with a 3-1 ARM, your rate will remain the same for the first three years, and then adjust every year thereafter.
Is an Adjustable Rate Mortgage a Good Choice?
Any mortgage you choose is a calculated risk you take based on your analysis of the current market, the changes you might expect the markets to make in the future, and your expectations for your personal financial circumstances. Since a mortgage is a long term commitment, it's hard to predict exactly what will happen.
For example: In a market where fixed interest rates are around 7%, and you find an ARM available at 5%, which has a nice long front end prior to adjustments (ex. it's a 5-3 ARM,) and a nominal adjustment rate (say: it can't go up more than 1.5% during any adjustment period,) and a capped rate you can live with (ex. it can never go above 8.5% during the lifetime of the loan, and it can also drop or remain the same depending on the index) you Could save quite a bit of money in the long run by purchasing this product.
But what if the fixed interest rate drops during that first 5 years, and everyone else is now paying 3.5 to 4% for a 30 year fixed rate loan? You may say to yourself: hmm, I'm paying 5%, and I'm set to have my rates readjusted next year. Will my rate be going up? Should I refinance? I should look into this!
If you find that the index is lower than when you purchased the loan, it's possible the rate won't go up.. in fact it could even go down, if the floor is lower than your initial interest rate. In this situation, refinancing would be expensive and not worth the work or closing costs. But if the floor of your ARM won't go below your initial interest rate... you could be headed for a higher cost mortgage than you need to carry. Then you need to consider how much it will cost to refinance, whether or not you'd save enough monthly to make it worthwhile, whether or not you're willing to add extra years to your mortgage and also whether or not your last two years of income, along with your credit score and income to debt ratio, will make you attractive enough to a bank for them to allow you to refinance.
Point being: you really have to read your fine print on an ARM, and understand it. Many people have saved a good deal of money by purchasing an ARM, but others haven't done as well; they've ended up being locked into very high rate mortgages.