How an ARM Mortgage Works

How does an ARM mortgage work? According to the Consumer Financial Protection Bureau (CFPB), adjustable rate mortgage (ARM) loan rates are calculated and adjusted based on factors including the initial rate and introductory period, index, margin, adjustment period and rate caps. When shopping for an ARM, it's important to compare each of these features along with payment amounts to find your best deal on an ARM loan.

ARM Mortgage Features Determine How Mortgage Rates Adjust

Each of these features contribute to how ARM rates change and when your mortgage payments will adjust.

Introductory rate and period: ARM loans typically provide an initial mortgage rate that is lower than market rate for fixed rate mortgages. This initial rate is limited to an initial period that can range from as little as one month for a standard ARM to three to ten years for hybrid adjustable rate mortgages. Hybrid mortgages offer an introductory low fixed rate for a period of years and are identified as 3/1, 5/1, 7/1 or 10/1 ARM loans. The first number identifies the number of years the initial period will last and the second number indicates the adjustment period, which in the case of hybrid ARM loans is typically one year. The Federal Reserve recommends that you ask for the annual percentage rate (APR) on each ARM quote you receive. In some cases, the initial rate may be very low, but the rate may adjust to accommodate deferred interest accrued during the initial period. It's important to know how much you could pay after the initial low rate expires.

Index: Mortgage lenders use specific financial index rates as the basis for determining rates for ARMs. The index used is specified in your mortgage document. The Federal Reserve provides examples of financial indexes commonly used by mortgage lenders include the One-year Constant Maturity Treasury Securities Index (CMT), Cost of Funds Index (COFI) and the London Interbank Offered Rate (LIBOR).

Margin: Each lender adds a percentage to the index rate to determine the mortgage rate charged for an ARM loan. If the index rate is 1.50 percent and the lender adds a margin of 1.00 percent, the ARM rate is 2.50 percent. It's worthwhile to shop and compare quotes for ARM loans as the index used and margins vary from lender to lender.

Adjustment intervals: This is the time between adjustments to your ARM rate. The most commonly used adjustment interval is once a year, but ARM loans can adjust at 3 or 5 year intervals. Verify the adjustment interval for each ARM quote you're considering.

Caps: ARM loans come with caps that limit how much ARM rates can increase or decrease. Periodic rate caps limit how much your mortgage rate can adjust at each adjustment period. Lifetime caps limit how much your mortgage rate can increase over the life of your ARM. If a periodic adjustment exceeds the lifetime rate cap, the rate increase on your ARM loan would be limited to the maximum rate specified by the lifetime rate cap. If your ARM rate is 5.50 percent and the periodic adjustment is 1.25 percent, but the life time cap is 6.50 percent, your ARM rate could only increase to the lifetime cap of 6.50 percent.

Tips for Considering ARM Loans

  • ARM loans can include features such as negative amortization; this can provide a very low initial rate but allows for unpaid interest to be collected later. Negative amortization causes your mortgage rates to increase more at later adjustment intervals.
  • While it's easy to focus on low introductory rates, it's important to understand how much your mortgage rate can potentially increase over the life of the loan. Steep increases in mortgage rates can quickly become unaffordable.
  • Compare fixed rate mortgage quotes with ARM quotes. Today's low fixed rates offer the security of stable principal and interest payments throughout the life of the mortgage.

ARM rates vary by lender. Close comparison of ARM quotes can help you find your best loan option.

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