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What is an ARM Loan?

what is an arm loan

Homebuyers and those looking to refinance their mortgages have multiple loan options, including fixed-rate mortgages or variable-rate mortgages. With each choice carrying its own features, benefits and risks, it can be challenging and confusing to navigate the differences between them.

In this article, we’ll take a look at one financing option in particular: the adjustable-rate mortgage (ARM). We’ll cover everything you need to know about ARMs and whether or not it’s the right loan for you.

Understanding adjustable-rate mortgages

Interest rates on mortgages fall into one of two camps: fixed or adjustable.

A fixed-rate mortgage is one in which the interest rate and payment do not fluctuate. They remain the same for the life of the loan unless it is refinanced. (An exception to that is if the loan has a graduated or stepped-up interest rate.)

An adjustable-rate mortgage is the opposite of a fixed-rate mortgage. It is one in which the rate and payment adjust throughout the life of the loan based on market fluctuations. They can go up or down along with the rise and fall of interest rates.

The unpredictability of an ARM can make it a precarious way to finance a home in some cases.

“What you’re doing when you’re taking out an adjustable-rate mortgage as a borrower is you’re exposing yourself to some interest rate risk,” said Tendayi Kapfidze, chief economist at LendingTree. “And the way that manifests itself in your real life is that your monthly payment is subject to change based upon what’s going to happen to interest rates.”

Because of that risk, ARMs generally come with lower interest rates than fixed-rate mortgages — at least initially.

How does an ARM work?

With an adjustable-rate mortgage, an initial interest rate is offered — again one that is typically lower than the going rate for a fixed-rate mortgage. After a specific amount of time, the interest rate changes based on a formula used by the lender.

Adjustable rate mortgages can vary in how they are structured, but the basic features of ARMs include the following:

  • The initial rate and payment. The introductory rate and payment on an ARM stay in effect for a specific amount of time, generally ranging anywhere from 1 month to 10 years.
  • The adjustment period. This refers to the amount of time between rate changes. With most ARMs, rates can change monthly, quarterly, annually or every three or five years. So a 1-year ARM has an adjustment period of one year, meaning the interest rate and payment change once every year throughout the life of the loan. A 5-year ARM adjusts once every five years.
  • Index. The interest rate on an ARM is based on two factors: the index and the margin. The index is a measure of interest rates that lenders use. Generally, if the index goes up, interest rates go up, too. If the index goes down, rates will go down.
  • Margin. The margin refers to the extra amount of percentage points a lender adds to the index to determine the interest rate you will pay, which is called the fully-indexed rate. The formula looks like this.

Index + Margin = Fully indexed rate

For example, if the index your lender uses is currently 3% and your lender’s margin is 3%, then the fully indexed rate would be 6% (3% + 3%). If the index rose to 5%, then the fully indexed rate would be 8% (5% + 3%). If the rate dropped to 2%, then the fully indexed rate would be 5% (2% + 3%).

Margins vary by lender, and not all ARMs adjust downward, so be sure to know the details of how your loan is structured.

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3 types of ARMs

There are three types of adjustable-rate mortgages, each one structured differently.

Interest-only

With an interest-only ARM, borrowers can pay only the interest due on the loan for a specific amount of time, usually anywhere from three years to 10 years. After the interest-only period, payments increase to include the principal for the remaining loan term.

For example, a 30-year ARM with a three-year interest-only period will have interest-only payments for the first three years, and then payments will include principal and interest for the next 27 years.

These loans start off with smaller payments and then increase once the principal is included — regardless of whether or not interest rates rise. With some loans, the interest rates adjust during the interest-only period, so if rates rise, then the interest-only payments will increase as well.

Payment option

In a payment-option ARM, borrowers choose among multiple payment options each month which typically include the following:

  • Principal and interest. These are traditional payments that reduce the principal owed on the loan and are usually based on a set loan term such as a 15-, 30- or 40-year payment.
  • Interest-only. These payments go toward the interest only and do not reduce the amount owed on the mortgage.
  • Minimum (or limited) payment. These payments may not be large enough to cover any principal on the loan or all of the interest due. Any unpaid interest will be added to the principal increasing the total amount of the loan as well as the total interest paid, and will result in larger future payments.

Hybrid

With hybrid ARMs, the interest rate is fixed for a specific amount of time and then adjusts for the remaining loan term. For example, a 30-year 10/1 ARM has a fixed rate for the first 10 years and then changes annually for the remaining 25 years.

What drives ARM rates?

As we touched on previously, the rates for adjustable-rate mortgages are based on an index plus the lender’s margin to total the loan’s indexed rate. Let’s take a deeper look at how that works as well as other factors that affect ARM rates.

Economic indexes

There are three common indexes that lenders use:

  • One-year constant-maturity Treasury (CMT) securities
  • Cost of Funds Index (COFI)
  • London Interbank Offered Rate (LIBOR)

These indexes differ from each other in their rates as well as how often they adjust. Your lender can give you details on which index they will use. Some lenders choose to use their own index.

Margin

The margin a lender uses (the additional percentage points added to your interest rate) may be based on your credit history, meaning the better your credit, the lower the margin and the less interest you will have to pay.

Caps

While homebuyers who finance with adjustable-rate mortgages assume quite a bit of risk, there are caps built into the terms to curb some of that risk.

There are two types of caps: interest-rate caps and payment caps.

  • Interest-rate caps: These limit the amount an interest rate can increase. There are two ways lenders can cap interest rates:
    • Periodic adjustment cap: This limits the amount the interest rate can go up or down from one adjustment period to the next after the first adjustment.
       
      Rate adjustments that are not made because of a cap can be applied to a future adjustment period, which is called a carryover.
    • Lifetime cap: This limits how much the interest rate can increase over the life of the loan. Legally, all ARMs must have a lifetime cap.
  • Payment caps: Many ARMs limit how much the monthly payment can increase. Like interest-rate caps, any payment increase that is not made because of the cap can be added to the principal on the loan.

Pros and cons of an ARM

If you are thinking about financing your home with an adjustable-rate mortgage, consider both the benefits and risks associated with this type of loan.

Pros

Lower payments. When compared with a fixed-rate mortgage for the same loan amount, ARMs start off with lower payments. But keep in mind that the payment could go up.

What an adjustable-rate mortgage does is it gives you an initial lower payment which sometime in the future — three years, five years, or seven years, [etc.] — is going to become a fixed payment and in the interim can go up and down,” Kapfidze said.

Lower interest rates. The initial or introductory rate of an ARM is typically lower than the rates of fixed-rate loans, providing some upfront savings.

Can increase your buying power. An adjustable-rate mortgage can allow a borrower to buy more home than they could with a fixed-rate mortgage with the same payment amount. Additionally, buyers who know that in the future they can handle a higher payment can leverage that ability before it occurs.

Potential long-term savings. If interest rates remain low for a good portion of the loan, then the cost of the loan would be cheaper than a fixed-rate mortgage.

Your interest rate could go down. If you enter an adjustable-rate mortgage while interest rates are high, and interest rates drop, your rate could potentially adjust down, depending on how your loan is structured. This is an advantage over a fixed-rate mortgage in which you would have to refinance to get a lower rate.

Cons

Unpredictability. There is no telling what can happen with interest rates making an ARM a potentially unstable and volatile way to finance your home. If you are not adequately prepared for a higher payment and cannot afford the payments, you could be in danger of losing your home.

The high cost of financing. You could end up paying significantly more in interest over the course of the loan than you would for a fixed-rate mortgage if rates fluctuate.

Payment shock. A significant increase in payment after an adjustment could catch you off guard, especially if the loan is also going from interest-only to principal and interest.

Negative amortization. Depending on how your loan is structured, it is possible to end up owing more than you borrowed, which is called negative amortization.

Prepayment penalties. With some ARMs, you may have to pay a fee if you choose to refinance or pay it off early.

Confusing terms. Many consumers take out ARMs without fully understanding how they work, setting themselves up for a potential rude awakening once the loan adjusts.

ARMs vs. fixed rate mortgages

According to Kapfidze, it could be advantageous for some homebuyers to pursue an adjustable-rate mortgage, even considering the risks involved. “Under the right circumstances, I think it’s a very appropriate product,” he stated.

Here is a look at when an ARM makes sense.

An ARM could work if:

  • You’re expecting an increase in your income. “One scenario where [you] would consider an ARM is if you are expecting with a high probability that you’re going to have an increase in income between now and the period in which the adjustable-rate mortgage becomes a fixed-rate mortgage,” Kapfidze suggested.
     
    For example, a physician or dentist who is completing their residency, or someone who is coming into an inheritance, a trust fund or a similar situation. He stresses the importance of being certain of the income increase, otherwise, you could put yourself in a dangerous position.
  • You can handle the higher payment but you’re just looking for some savings. According to Kapfidze, an adjustable-rate mortgage could work for homebuyers who are merely looking for a deal on interest rates. “If you just want to save some money now and you think with your current income you can handle a high payment in the future, then it’s completely appropriate as well.”
  • You will be leaving the home before the adjustment period. If you know you will be moving or selling your home before the adjustment period, then an ARM could work to your advantage. However, keep in mind that there is no guarantee your home will sell within the desired timeline.
  • You plan to refinance before the adjustment period. Some consumers take out an ARM loan with a plan to refinance to a fixed rate before the rate adjusts, though Kapfidze says that path is not without risk or cost.
     
    “It is possible that you may have an opportunity to refinance, but even if you do that, you’re still exposing yourself to some interest rate risk because you don’t know where rates are going to be in the future,” he said. “If rates are materially higher, that’s going to cost you a lot more money.”  
     
    Additionally, “There are going to be some costs related to refinancing, so you have to be prepared for that,” Kapfidze cautioned.

A fixed-rate mortgage is best for you if:

  • Your budget is tight. If the initial payment on the ARM is already toward the upper part of your budget and a higher amount would be a stretch, then you are better off going with a fixed rate.
  • If the uncertainty will affect your overall financial situation. “The great thing about a fixed-rate loan,” said Kapfidze, “is that you know with certainty the payment is not going to change. You know what kind of risk that you’re exposed to.”
  • You are risk averse. “If you’re not comfortable with stock market risk, then you probably shouldn’t be taking this type of risk on your liabilities,” Kapfidze warned.

Is an ARM right for you?

For those considering an adjustable-rate mortgage, Kapfidze stresses the importance of having a firm understanding of how your loan works and what you could potentially face down the road.

“It’s just a matter of making sure, or at least having a plan, as to what happens if the rate goes up,” he said.

Kapfidze suggests walking out the “worst-case scenario” of the loan by asking your lender what the highest payment you could possibly face would be. They will be able to tell you, based on the structure of the loan what the maximum potential fixed rate you’ll be paying in the future would be.

“The interest rate risk can translate into a real tangible dollar amount,” Kapfidze said. For example, “It could be that today your payment is $800, but in the worst-case scenario, your payment is going to go to $1,200. So make sure you get that calculation from the lender and get comfortable with that number and [know] that you can meet it.”

Putting the interest rate and the potential increase into real dollars can help you make an objective decision on whether or not an adjustable-rate mortgage is the right loan for you.

 

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