Adjustable-Rate Mortgage: Meaning, Definition &; Types

Modified date: October 29, 2023

A house loan with a variable interest rate is called an adjustable-rate mortgage (ARM). The starting interest rate on an ARM is set for a specific time. Following then, the interest rate charged on the unpaid balance resets sporadically, sometimes every month.

ARMs are also known as floating mortgages or variable-rate mortgages. An additional spread known as an ARM margin is added to the benchmark or index used to reset the interest rate for ARMs. Until October 2020, the standard index used in ARMs was the London Interbank Offered Rate (LIBOR).

Keep on reading to know more about the adjustable-rate mortgage.

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How Does an Adjustable-Rate Mortgage Work?

Homeowners can use mortgages to finance the acquisition of a house or another piece of real estate. When you obtain a mortgage, you will be required to pay back the borrowed amount over a predetermined period of years, as well as an additional amount to make up for the lender’s worries and the possibility that inflation will reduce the value of the balance by the time the funds are returned.

Most of the time, you can select the mortgage loan that best meets your requirements. An interest rate that remains constant for the duration of a fixed-rate mortgage. Your payments stay unchanged as a result—an ARM, where the rate changes depending on the market. As a result, you stand to gain from declining rates while simultaneously running the risk of rates rising.

If you choose an ARM, carefully read the fine print to know what to anticipate. Otherwise, your budget might be in for an unpleasant surprise if your monthly payment rises. The following categories of interest rate caps are used to limit rate increases:

Initial cap: During the initial time, all ARMs have a set rate at their starting point. The initial cap is the highest. The interest rate can go above the starting rate once that period is over and the first adjustment is made. Typically, this is 2% or 5%.
Periodic cap: Also known as a subsequent adjustment cap, this restricts the amount by which the interest rate may fluctuate at any time. The usual periodic cap is 2 percent.
Lifetime cap: This limits how much the interest rate can change throughout the mortgage. Usually, it is 5%. Your rate will always be at most 10% if you have an ARM with a lifetime cap of 5% and an initial fixed rate of 5%. In contrast, your rate will always stay above the set speed, which in this example is 5%. There is almost always a lifetime cap on ARMs.

Three-digit ratios are frequently used to represent rate caps. A 2/1/5 ARM, for instance, would have a 2% starting cap, a 1% monthly cap, and a 5% lifetime cap.

Another crucial aspect to consider is whether an ARM is made up of conforming or nonconforming loans. Conforming loans adhere to the guidelines set by GSEs like Fannie Mae and Freddie Mac.

Advantages of Adjustable-Rate Mortgage

Lessening of Payments and Interest Rates: You can get low-interest rates by selecting an ARM. As general interest rates climb, ARMs become more alluring. This is because interest rates on ARMs are typically much lower than those on fixed-rate loans. You’ll have cheaper monthly payments as a result of decreased interest rates. Your rates will change after your fixed-rate period expires. However, it’s not a given that higher rates will result from this. Your rate will be reduced if interest rates decline to remain competitive with current offers. Remember that your rates may also increase. Your lender will raise the interest on your mortgage if you are nearing the end of your fixed rate period and your current rates are higher than your current ARM rate.
Pay the mortgage principal faster: A lower interest rate means a more significant portion of each payment will go toward the loan’s principal. As a result, you can reduce your principal faster and increase the value of your home. Remember that your ARM loan’s monthly payment is already lower than it would have been with a conventional fixed-rate mortgage. As a result, you can invest a portion of those savings in your house. You could make additional ARM loan payments to lower your principal debt even more quickly. Since ARM loans have no prepayment penalties, you won’t be charged extra money if you fully pay off your loan.
Acquire more homes: Like most buyers, you likely built your housing budget on the monthly payment amount rather than the overall cost of the property. An ARM can be the best choice if you’ve been looking for a way to purchase more properties. If you have an ARM loan, you can spend less on initial interest fees and more on your principal mortgage payment. Your monthly payment can change by $200–$300 depending on the interest rate, even by just one percentage point.
The Prospect of a Lower Payment Following the Fixed Period: Your lender will review your ARM loan and revise your rate once your fixed rate period is up. They will increase it if the rates are higher than your present rate. The good news is that your rate may decrease along with falling interest rates.

Disadvantages of Adjustable-Rate Mortgage

The interest rate may change, which is one of the main drawbacks of ARMs. This means that your monthly mortgage payment will increase if market conditions result in a rate increase. And that could hurt your monthly spending plan.
Although ARMs may provide more freedom, they offer you a different level of dependability than fixed-rate loans. Due to the constant interest rate, borrowers with fixed-rate loans are aware of their payments for the duration of the loan. However, as the rate fluctuates with ARMs, you’ll need to adjust your budget as the rate changes.
Even the most experienced borrower may sometimes need help to grasp these mortgages. Before you sign your mortgage contracts, you should be informed of several elements associated with these loans, including caps, indices, and margins.

Types of Adjustable-Rate Mortgage

1. Hybrid ARMs

A hybrid adjustable mortgage rate (ARM) has an interest rate initially set and later fluctuates. The term “hybrid” describes the ARM’s combination of fixed-rate and adjustable-rate features. Hybrid ARMs are identified by the initial fixed-rate and adjustable-rate periods; for instance, 3/1 designates an ARM with an initial fixed interest-rate period of three years and subsequent interest-rate adjustment periods of one year.

The reset date of a hybrid ARM is the day it changes from a fixed-rate payment plan to an adjustable payment schedule. After the reset date, a hybrid ARM behaves like a regular ARM floating at a margin over a defined index.

2. Optional ARMs

Typically a 30-year ARM, an “option ARM” gives the borrower four alternatives for starting monthly payments: a predetermined minimum payment, an interest-only payment, a 15-year thoroughly amortizing cost, and a 30-year fully amortizing payment. These loans are known as “pay-option” or “pick-a-payment” ARMs.

“Negative amortization” refers to the process whereby the unpaid portion of the accrued interest is added to the outstanding principal balance when a borrower makes a Pay-Option ARM payment less than the accruing interest.

Option ARMs are sometimes offered with meager teaser rates (typically as low as 1%), resulting in highly cheap minimum payments for the ARM’s first year.

How Qualify For an Adjustable-Rate Mortgage?

Although conventional adjustable-rate mortgages and fixed-rate mortgages have similar fundamental eligibility requirements, conventional adjustable-rate mortgages have tighter credit requirements. We’ve highlighted this along with some additional distinctions you need to be aware of:

For a traditional ARM, a larger down payment is required. The minimum down payment required under ARM lending rules is 5%, as opposed to the 3% required by fixed-rate conventional loans.
For traditional ARMs, your credit score must be more significant. For a standard ARM, you might require a score of 640 instead of 620 for fixed-rate loans.
You might have to meet the worst-case requirement. Some ARM programs demand that you qualify at the highest interest rate based on the conditions of your ARM loan to ensure that you can repay the loan.
A VA ARM will provide you with additional payment adjustment protection. For any VA ARM product that adjusts in fewer than five years, eligible military borrowers enjoy extra security through a cap on annual rate hikes of one percentage point.

Frequently Asked Questions

How Are Interest Rates on Adjustable-Rate Mortgage Calculated?

When setting ARM interest rates, lenders take into account two factors:

The index is a reference rate that is based on broader economic trends. It is based on an index, with different lenders using different indices, such as the Constant Maturity Treasury (CMT) rate or the U.S. prime rate.
The amount of percentage points the lender adds to the index after the initial period is known as the ARM margin.
The lender will add the margin to the index to determine your new interest rate after the fixed-rate period expires, and you become eligible for periodic adjustments.

Is an Adjustable-Rate Mortgage a Smart Option?

An ARM is an excellent option for a borrower looking to benefit from short-term cheap interest rates. When borrowing rates are lowered, they can also help homeowners save money. However, some homeowners could feel anxious due to their inherent volatility. To manage potentially more outstanding monthly payments in the future, you’ll need a reliable source of income and a sizeable emergency reserve.

How is an Adjustable-rate mortgage calculated?

The cost of borrowing will change after the original fixed-rate period expires based on a reference interest rate, such as the prime rate, the London Interbank Offered Rate (LIBOR), the Secured Overnight Financing Rate (SOFR), or the rate on short-term U.S. Treasury bonds. The lender will add its fixed amount of interest to pay on top of that; this is referred to as the ARM margin.

Conclusion

When a borrower wants to finance the acquisition of a home or another type of property, they have various choices. Mortgages with fixed or adjustable rates are both options. While the former gives you some stability, ARMs provide lower interest rates upfront before their rates change in response to the market. ARMs come in a variety of varieties, each with advantages and disadvantages.