What is an adjustable-rate mortgage?

There are two main types of mortgages: a fixed-rate mortgage where your interest rate never changes, and an adjustable-rate mortgage (ARM) where your interest rate goes up or down periodically based on pre-selected market indexes. However, ARMs also have a fixed-rate period before the adjustment period takes hold.

Adjustable-rate mortgages are appealing for some because, during that initial fixed-rate phase, interest rates can be lower than traditional 30-year fixed-rate mortgages. Since mortgage payments are structured so that interest is paid off sooner, that lower ARM rate at the outset means more of your monthly payment can go toward paying down the mortgage balance, and that means you build equity faster.

But for all the potential short-term advantages of ARMs (and the possibility that rates could actually go down during the adjustment period) you’re still assuming a ton of risk in the long run. If you don’t have a plan for the variable-rate phase of the mortgage, or if you don’t know the first thing about indexes, margins, and caps (which we’ll go over momentarily), getting an ARM may not be the best idea.

In this article:

• How are ARM interest rates determined?
• What is an adjustable-rate mortgage cap?
• What kind of adjustable-rate mortgages are there?
• When adjustable-rate mortgages make sense
• When adjustable-rate mortgages don’t make sense

How are ARM interest rates determined?

Although every bank has its own unique mortgage offerings, they all generally use the same methods for determining interest rates. Your rates are determined by market indexes, margins for determining the interest rate for each individual mortgage, and caps which limit how much your interest rate and monthly payment can change. Caps also put a “ceiling” or maximum allowable interest rate on your ARM.

Market indexes

Your ARM interest rate is based on the major market indexes: the London Interbank Offered Rate (LIBOR), the Cost of Funds Index (COFI), and one-, three-, and five-year U.S. Treasury security yields. After the initial fixed-rate period ends, your ARM will move up or down depending on what index it’s tied to.

Margins

To set your ARM rate, your lender adds a certain amount of percentage points, or margins, to the index rate. The sum of the two is known as the indexed rate. For example, if the index is 3% and your margin is 2.5%, your indexed rate would be 5.5%.

Some mortgage companies may base your margin amount on your credit score — the higher your credit score, the lower your margin, and vice versa.

When comparing ARMs, be sure to look at the index and the margin of each mortgage product. You should also keep in mind that although your margin stays the same, the index rate will change as the market fluctuates.

What is an adjustable-rate mortgage cap?

Adjustable-rate mortgages also come with caps, which are consumer safeguards that are used to limit rate and payment increases. Caps come in a few different forms, which include:

Interest caps

Interest caps limit how much the interest rate can change during an adjustment period. There are two types of interest caps:

• An initial adjustment cap, which says how much the interest rate can change the first time it adjusts after the fixed period ends
• And a subsequent adjustment cap, which says how much the interest rate can increase in the adjustment periods that follow that initial adjustment

Payment caps

Payments caps limit the amount that your monthly loan payment can change during your adjustment period. Usually this cap will be indicated as a percentage of your current mortgage payment. Payment cap options on mortgage loans are all but nonexistent in today’s market.

Lifetime cap

Lifetime caps limit how much your interest rate can increase over the lifetime of the loan.

How caps can lead to negative amortization

There’s a caveat to be aware of with payment caps. Any interest you don’t pay because of the cap could be added to your loan balance, and if your loan balance is greater than what you started with, you have negative amortization.

However, as we just mentioned, payment caps (and negative amortization features) have mostly been phased out of the mortgage industry.

What kind of adjustable-rate mortgages are there?

There are a few different types of ARM mortgage products on the market: hybrid ARMs, interest-only ARMs, and payment-option arms.

Hybrid ARMs

Hybrid ARMs are the most widely available variable-rate mortgage product on the market today. There are a few main types of hybrid arms — marketed as 3/1, 5/1, 7/1, and 10/1 ARMs, where the first number tells you how long the fixed-rate phase will be, and the second number tells you how often the rates adjust after the initial period.

• Initial interest rate — during the initial fixed-rate part of your term, your interest rate stays the same for the period of time outlined in your mortgage agreement. The initial rate for ARMs is typically lower than a typical 30-year, fixed-rate mortgage, which can make adjustable-rate mortgage products enticing for potential homebuyers.

But once the initial rate period ends, your rates may fluctuate depending on market trends.

• The adjustment period — once your fixed-rate period ends, your interest rate could change every month, every quarter, every year, or every few years. Your mortgage agreement will clearly state how long your adjustment period lasts.

With a 7/1 mortgage, for example, the fixed-rate period would last seven years, and your mortgage can adjust once per year after that. If you had a 7/2 mortgage, your mortgage can adjust every two years after the initial period.

Interest-only ARMs

With interest-only (I-O) ARMs, you only pay interest for a set number of years, typically between three and 10, and then you make higher payments of principal plus interest for the remainder of the mortgage term. Your payments are typically low during the I-O period, but paying interest only doesn’t help you pay off the home. Most lenders also require a high minimum down payment for I-O loans.

Payment-option ARMs

Payment-option ARMs were pretty much zapped from the mortgage market after the 2008 housing crisis, and for good reason. With payment-option ARMs, the borrower chooses from a number of monthly payment options, which typically include:

• a traditional principal-plus-interest scheduled payment on a 30-year amortized schedule
• an interest-only payment
• a minimum payment payment that doesn’t cover the interest; the interest you don’t pay will be negatively amortized

Read more about mortgage amortization.

When adjustable-rate mortgages make sense

Hybrid ARMs generally have lower interest rates during the initial fixed-rate period than your standard 30-year fixed-rate mortgage. That means you’re making lower monthly payments during that initial phase.

You may also be building equity faster. A lower interest rate means more of your monthly payment can go toward paying down the principal balance of the mortgage, and that means a better equity position than if you went with the fixed-rate option.

Adjustable-rate mortgages also may be advantageous for borrowers who don’t plan to stay in the home long, or who simply bought the home as a fixer-upper. If you have a plan in place for selling during the fixed-rate period before rates go up, then a hybrid ARM makes sense.

There’s also the possibility with ARMs that your payments could actually get smaller after the fixed-rate period. If index rates go down, then there’s a possibility that your monthly payment could too.

When adjustable-rate mortgages don’t make sense

On the flip side, you also run the risk of your monthly payments skyrocketing once the initial fixed period ends. If interest rates unexpectedly rise and you’re not financially prepared to account for the sudden increase, you could default on your loan payments and ultimately lose your home to foreclosure.

Even if you do have a plan to sell your home once interest rates become variable, there’s no guarantee that you’ll be able to sell or refinance into lower rates. Additionally, housing prices may not increase fast enough to make up for the faster growth of equity, and housing prices could also go down.

Adjustable-rate mortgage contracts are also more complex than fixed-rate loan contracts, as there are more payment variables. With a fixed-rate mortgage, you may be paying more, but at least you understand exactly what you’re paying and you don’t have to worry about indexes or margins or caps. If you’re not financially savvy, you could be way in over your head with an ARM.