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The interest rate for an adjustable-rate mortgage is a variable one. The initial interest rate on an ARM is set below the market rate on a comparable fixed-rate loan, and then the rate rises as time goes on. If the ARM is held long enough, the interest rate will surpass the going rate for fixed-rate loans.
ARMs have a fixed period of time during which the initial interest rate remains constant, after which the interest rate adjusts at a pre-arranged frequency. The fixed-rate period can vary significantly—anywhere from one month to 10 years; shorter adjustment periods generally carry lower initial interest rates. After the initial term, the loan resets, meaning there is a new interest rate based on current market rates. This is then the rate until the next reset, which may be the following year.
ARM Terminology
ARMs are significantly more complicated than fixed-rate loans, so exploring the pros and cons requires an understanding of some basic terminology. Here are some concepts borrowers need to know before selecting an ARM:
- Adjustment Frequency: This refers to the amount of time between interest-rate adjustments (e.g. monthly, yearly, etc.).
- Adjustment Indexes: Interest-rate adjustments are tied to a benchmark. Sometimes this is the interest rate on a type of asset, such as certificates of deposit or Treasury bills. It could also be a specific index, such as the Secured Overnight Financing Rate (SOFR),4 the Cost of Funds Index or the London Interbank Offered Rate (LIBOR).
- Margin: When you sign your loan, you agree to pay a rate that is a certain percentage higher than the adjustment index. For example, your adjustable rate may be the rate of the one-year T-bill plus 2%. That extra 2% is called the margin.
- Caps: This refers to the limit on the amount the interest rate can increase each adjustment period. Some ARMs also offer caps on the total monthly payment.7 These loans, also known as negative amortization loans, keep payments low; however, these payments may cover only a portion of the interest due. Unpaid interest becomes part of the principal. After years of paying the mortgage, your principal owed may be greater than the amount you initially borrowed.
- Ceiling: This is the highest that the adjustable interest rate is permitted to reach during the life of the loan.
The biggest advantage of an ARM is that it is considerably cheaper than a fixed-rate mortgage, at least for the first three, five, or seven years. ARMs are also attractive because their low initial payments often enable the borrower to qualify for a larger loan and, in a falling-interest-rate environment, allow the borrower to enjoy lower interest rates (and lower payments) without the need to refinance the mortgage.
A borrower who chooses an ARM may save several hundred dollars a month for up to seven years, after which their costs are likely to rise. The new rate will be based on market rates, not the initial below-market rate. If you’re very lucky, it may be lower depending on what the market rates are like at the time of the rate reset.
The ARM, however, can pose some significant downsides. With an ARM, your monthly payment may change frequently over the life of the loan. And if you take on a large loan, you could be in trouble when interest rates rise: Some ARMs are structured so that interest rates can nearly double in just a few years. (For more, see Adjustable Rate Mortgage: What Happens When Interest Rates Go Up.)
Indeed, adjustable-rate mortgages went out of favor with many financial planners after the subprime mortgage meltdown of 2008, which ushered in an era of foreclosures and short sales. Borrowers faced sticker shock when their ARMs adjusted, and their payments skyrocketed. Fortunately, since then government regulations and legislation have been instituted to increase the oversight that transformed a housing bubble into a global financial crisis. The Consumer Financial Protection Bureau (CFPB) has been preventing predatory mortgage practices that hurt the consumer. Lenders are lending to borrowers who are likely to repay their loans.