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What is an ARM Loan?

what is an arm loan

Adjustable-rate mortgages, or ARMs, are a method for financing your home. Getting an ARM loan has benefits and disadvantages depending on your situation. Before you commit, you’ll want to know which category you fall into, so you can choose whether an ARM is the best path for you.

Understanding ARM Terms

  • Index: An ARM loan’s interest rate after the initial fixed rate has passed is connected to an interest rate index. The index is used to determine future interest rates.
  • ARM Margin: This is a fixed interest rate that is calculated into the lifespan of the loan. When calculating the total interest rate of an ARM loan— add the index rate to the margin rate. The consistent and fixed margin rate should be known to you from the start of the mortgage.
  • Lifetime Caps: Over the lifespan of the loan, this cap restricts how high the rate can rise.
  • Adjustment Caps: From one interest rate to the next, this cap restricts how high the rate can rise.

What is an ARM?

Again, ARM is short for “adjustable rate mortgage.” It’s a home loan with an interest rate that changes based on the movements of an interest rate index.

Major Indexes

There are three interest rate indexes that dictate ARM rates:

  1. One-year Treasury bill. Also known as a T-bill, this is the short-term debt obligation of the United States with a maturity of less than one year, and tracked by the Federal Reserve Board.
  2. 11th District Cost of Funds Index (COFI). COFI is an index calculated from the interest expenses of savings Institutions in Arizona, California, and Nevada.
  3. London Interbank Offered Rate (Libor).Libor is the interest rate international banks are charging each other for large loans.

Fixed vs. ARM

Both fixed and ARM mortgages provide financing to allow you to realize home ownership. However, each is structured differently. With a fixed mortgage, interest rates stay the same for a 15 or 30-year span, so your payment amount never fluctuates. With a ARM mortgage, the interest rate can change, so your monthly payments may go up or down. There are three types of ARM mortgages to choose from, with various sub-types within each.

3 Types of ARM Mortgages

  • Interest-only

Looking for fixed monthly payments for a period of time with the benefit of a lower monthly payment? An interest-only loan comes with an initial fixed interest rate spanning between five to ten years. During the fixed rate period, payments made only go toward the mortgage’s interest— the loan’s principle stays untouched. At the end of the initial fixed rate time span, the interest rate on the mortgage changes annually.

  • Payment option

Looking for a home loan with payment options on a monthly basis? A payment option loan allows you to do just that—a minimum payment, interest only payment, or a fully amortizing payment with a time span of 15, 30, or 40 years. With this option, flexibility is your ally.

  • Hybrid

Looking for some monthly payment predictability for a period of time with the ability to still take advantage of interest rates without refinancing? A Hybrid ARM loan comes with an initial fixed rate of either three, five, seven, or ten years. These are known as 3/1, 5/1, 7/1,and 10/1 ARMs. After the initial interest rate’s time has passed, the interest rate on the loan changes every year.

Pros

Now let’s take a look at some pros of getting an ARM loan. Here are four to consider.

  • Investment home

If you are looking for an investment home to flip and sell in a short time, an ARM loan’s initial interest rates will be your friend — or if you know there is a move in your future but still want the benefits of owning your own home.

  • Qualify for more home

Want a bigger home? With an ARM, lenders are able to use the loan’s initial low interest to qualify buyers and borrowers for a larger overall mortgage than with a fixed mortgage.

  • No need to refinance

Avoiding the challenges of refinancing every time interests rates fall is one of the greatest assets to an ARM mortgage. With an ARM loan there is no need to pay closing costs to take advantage of dropping interest rates in the market—if interest rates drop so does your monthly payments without any effort on your part!

  • Save and add to financial security

When the ARM loan’s interest rate saves you money, use it to your advantage—save and add to your financial security by investing in a new asset or retirement plan or pay down debt.

Cons

There are three things you should consider before getting an ARM mortgage:

  • Yo-yoing rates

Just like the stock market, with an ARM mortgage, interest rates go up and down.

  • Budgeting Challenges

Trying to budget for your mortgage and housing expenses can be challenging when your monthly payment shifts. If the rate of the home loan rises too high for your monthly payment to be financially manageable, you may find yourself in default or facing foreclosure if you are unable to make payments.

  • Hard to understand

Unlike the straightforward nature of a fixed-interest mortgage, understanding exactly how an ARM works can be complicated. There is a great handbook on ARM loans by the Federal Reserve to help.

Is an ARM Mortgage for You?

Whether an ARM is for you or not will depend on why you are buying a home. If you know you will be moving or selling in the next one to five years, then an ARM loan may be a solid choice for you. If you are buying a home for the long haul, and envision yourself in the same home for a longer period of time then the initial fixed rate time spans of ARM loans, you may want to look into getting a traditional fixed-rate mortgage for 15 or 30 years.

More Information

Here’s more info on ARM mortgages:

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