Understanding Adjustable Rate Mortgages (ARMs)

An adjustable rate mortgage, or ARM for short, is one of two primary types of mortgage loans.   It differs from a fixed-rate mortgage in that the interest rate for an ARM can go up or down over time, depending on various factors.  As such, ARMs are more complicated than their fixed-rate counterpart.  So determining if an ARM best suits your needs requires an understanding of how it works.  Here is a layman's look at the basics of ARMs.

Adjustment Period
When you get an adjustable rate mortgage, you usually start out with a fixed interest rate for a specified period of time.  When that period ends, your rate can change at preset intervals.  The time between those intervals is the adjustment period.  The figures that describe an ARM clue you in on the length of the adjustment period.  For instance, with a 3/1 ARM your interest rate would be fixed for three years after which the rate could adjust every year for the remainder of your loan term.

The Index
When a rate adjustment takes place, it is based on the economic index that the rate is linked to.  When the index goes up, so do your interest rate and mortgage payments in most cases.  Likewise, when the index goes down, your rate and payments may drop accordingly.   Now, the specific index on which lenders base ARM interest rates varies.  Among the more common indexes are rates on United States Treasury securities (1-year, 3-year, and 5-year), the national or regional cost of funds to savings and loan associations, and the London Interbank Offered Rate (LIBOR), which is the rate most international banks charge each other on large loans.

The Margin
When lenders determine your initial interest rate, they add percentage points to the index rate they are using as a base.  You can think of this "margin" as the lender markup.  It covers their cost of doing business and includes the profit they make on your loan.   Margins vary from one lender to another, however, they usually remain constant over the life of a given loan.

Rate and Payment Caps
Most ARMS have limits, called caps, that determine how much your rate and payments can increase.  There are two types of rate caps -- periodic and lifetime.  The periodic cap limits how many percentage points your interest rate can rise at any one time.  A lifetime cap sets the maximum that your rate can increase over the loan term.   Periodic caps are not found on all ARMs, however by law virtually all ARMs must have a lifetime cap.  Some ARMs also offer payment caps.  These limit the amount your monthly payment can increase at adjustment time.  Be aware that many ARMs with payment caps do not have periodic interest rate caps.

Negative Amortization
If there is a payment cap on your adjustable rate mortgage, you could encounter negative amortization.  This means that your mortgage balance increases instead of decreases.  How?  The payment cap limits how much your mortgage payments go up.  If the limit on your payments creates a shortage in covering the interest due, that unpaid amount is added back to your loan where it continues to generate more interest debt.  You could end up owing your lender more than you originally borrowed.

A conversion clause in your loan agreement allows you to convert the ARM to a fixed-rate mortgage at designated times.  Your new rate at the time of conversion will be the current market rate for fixed-rate loans.  Your lender may charge additional up-front fees or a higher interest rate for a convertible ARM.  However, you do have future flexibility should your circumstances change and you no longer wish to be subject to rate and payment fluctuations.

With so many nuances and the risk involved in fluctuating rates and payments, why are ARMs popular?  The initial interest rate on an ARM is typically lower than that on fixed-rate mortgages.  This means you could qualify for a larger loan.  Also, if you plan to stay in your home for only a few years, the potential for increases might not be a big factor.   And if the rates go down, your payments could go down as well.  Of course, as with any other type of mortgage loan, you should weigh the pros and cons of an ARM.   Be sure to ask what index will be used, how often it changes, how it has fluctuated in the past, and if you can convert to a fixed-rate in the future.

Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.