What is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage (ARM) is a home loan with an interest rate that varies throughout the term of the loan. The common alternative to an ARM is a fixed-rate mortgage, which has an interest rate that doesn’t change. ARMs come with a pre-set margin that doesn’t change, and are tied to a major mortgage index. That means the bank can’t arbitrarily choose a mortgage rate—it stays true to the market.
How does and ARM work?
At the beginning of your term period, an ARM will usually have a lower initial rate. This is also called a teaser rate. For a certain period of time, you will enjoy a lower rate than what you would be able to get with a fixed rate loan. After the teaser period ends, the ARM will adjust to its fully-indexed rate. This is the fixed margin plus the index. An ARM’s interest rate will move up and down according to its index.
You can find your fully-indexed rate each month by adding your margin to the major mortgage index that your loan uses. Your loan paperwork will specify what margin and index you’ll be using.
What stops ARMs from skyrocketing?
ARMs come with a safeguard—interest rate adjustment caps. These limit the amount that your rate can change that can occur within a certain period. Caps are often structured as 6/2/6. That means that the rate can change 6% after the introductory period, 2% periodically or 6% throughout the entire life of the loan. These caps allow your interest rate to go both up and down. If the market improves, your interest may also go down—however, your lender may put a floor on your interest rate so that it doesn’t go below the initial rate.
Why use an ARM?
The main attraction of an ARM is that beautiful teaser rate. The lower initial payments are great for buyers who intend to refinance into another ARM or fixed rate mortgage. It’s also beneficial for buyers who don’t intend to live in the home long term, or see the home as a short-term investment. If you decide that you’re going to move out of the home in five years, and ARM is probably a good move for you.
Why shouldn’t you use an ARM?
If interest rates go up after your teaser period, your payments will increase. That seems like an obvious statement, but what it really means is that you’re taking on more risk. If you’re not ready for a spike in your mortgage rate and you start to miss your payments, you could end up defaulting on your loan.
Some ARMs come with a prepayment penalty which may occur if you refinance or sell your loan. This negates the value of an ARM if you plan to sell your home before the teaser period has ended, so if you plan to sell your home within the first five years, ask for a loan without this rate.
Before you get an ARM you should know your plan, the terms of your loan, and the worst case scenario. How long do you plan to stay in the home? If you keep your ARM past the introductory period, will you be able to pay regardless of the situation? What are the terms of your ARM? Is there a penalty for repaying your loan early? As long as you know what you’re signing up for, an ARM may be a good option for you.