An adjustable-rate mortgage (ARM) refers to a mortgage loan with an interest rate that changes over the life of the loan. It may also be referred to as a variable-rate mortgage or a floating mortgage.
The terms of the variable interest rate are set at the beginning of the mortgage. At that time, the frequency of variation is established along with the loan period. This is distinct from a fixed-rate mortgage, which has a set mortgage interest rate that will not change over the life of the loan.
Related: Adjustable Rate Mortgage (ARM)
Adjustable-Rate Mortgage Characteristics
There are two numbers used to describe adjustable-rate mortgages. The first number represents the number of years the mortgage rate remains fixed. The second number usually represents the frequency of changes in the interest rate.
ARMs can vary at different intervals; however, the interval is always established before closing on the mortgage.
- A 5/25 ARM is a 30-year mortgage with the first five years fixed, and the remaining 25 years adjustable.
- A 5/1 ARM is a mortgage that has a fixed rate for the first five years, then switches to an adjustable-rate mortgage for the remainder of its term during which the interest rate can be adjusted up or down annually, depending on several factors.
The period of time between mortgage rate changes with an ARM is called the adjustment period. For example, a mortgage loan is described as a 1-year ARM if it has an adjustment period of one year.
Adjustable-rate mortgages can be taken out for various periods of time. However, they are commonly taken out for shorter periods, such as 15 years or less, rather than 25-30 years.
How Rate Changes Are Calculated
With a variable mortgage rate, borrowers can expect to see changes in the interest rate of their loan at the start of the adjustment period. Interest rate adjustments are not arbitrary. Instead, they are based on a few specific factors, notably indexes and margins. Certain interest rate caps are also applied to most consumer ARMs.
Most adjustable-rate mortgages are tied to a specific interest rate index. The common indexes are:
- Maturity yield on 1-year U.S. Treasury bills.
- 11th District cost of funds index.
- London Interbank Offered Rate.
In general terms, the interest rate for an ARM moves up and down as the index to which it is tied moves up and down. Therefore, choosing an ARM tied to an index that is less likely to go up can result in a lower interest rate over the term of the loan.
The margin of an ARM is the percentage the lender charges over the index interest rate. If a loan has a 2% margin, 2% is added on top of the index price to calculate the mortgage interest rate.
So, for example, if the index that the loan is tied to is at 1.5% and there is a 2% margin, the borrower’s interest rate will be 3.5%.
To protect borrowers from excessive mortgage rate increases during a particular adjustment period, mortgage interest rate caps are usually put in place. A rate cap can be done in one of two ways:
- Lifetime Rate Cap: This is an interest rate cap that prevents the mortgage interest rate from going above a certain percent over the life of the loan. Most ARMs in the U.S. are legally required to have a lifetime cap, even if they also have a periodic rate cap.
- Periodic Rate Cap: This applies to increases in the interest rate during each adjustment period. A periodic rate cap prevents the mortgage interest rate from increasing or decrease by more than a certain percentage each time.
Changes in the interest rate of an ARM are calculated by applying the interest rate caps, change in the index value, and the margin.
Considerations for Home Buyers
Adjustable-rate mortgages tend to be riskier than fixed-rate mortgages, because it is difficult to predict the change in interest rates during the life of the loan. Although ARMs often have lower rates at the beginning, they may have higher rates later if interest rates rise.
ARMs are generally better for homebuyers who plan to pay off their mortgage quickly, since a shorter-term mortgage has less risk of being affected by rising interest rates. Likewise, buyers looking for a long-term mortgage loan are often better served with a fixed-rate mortgage.