What is an Adjustable Rate Mortgage (ARM)?

An adjustable rate mortgage (ARM) is a type of mortgage loan where the interest rate can change over the course of the loan term [1]. This differs from a fixed-rate mortgage, where the interest rate stays the same for the entire loan.

With an ARM, there is typically an initial fixed-rate period, often 5, 7 or 10 years. During this time, the interest rate stays stable. After the fixed-rate period ends, the rate can adjust periodically, usually once per year [2]. The adjustment is tied to an index like the U.S. Prime Rate or LIBOR.

The initial fixed-rate period allows borrowers to lock in a low rate for several years. However, ARM rates can change dramatically after adjustment, leading to uncertainty in long-term costs. This potential for fluctuation is the key tradeoff compared to the stability of fixed-rate mortgages.

How Does an Adjustable Rate Mortgage Work?

An adjustable rate mortgage (ARM) works differently than a fixed rate mortgage. With a fixed rate mortgage, the interest rate stays the same for the entire loan term. But with an ARM, the interest rate can go up or down at certain intervals during the loan term [1].

The initial interest rate on an ARM is fixed for a set period, usually 5, 7 or 10 years. After that initial fixed-rate period, the interest rate can adjust up or down based on market conditions. The adjustment is tied to an index like the LIBOR or Treasury securities. Lenders add a margin to the index value to determine the new interest rate at each adjustment period [2].

For example, if the index is 2% and the lender's margin is 3%, the fully indexed rate would be 5%. If the initial fixed rate was 4%, it could adjust up to 5% at the first adjustment. Rate caps limit how much the rate can change at each adjustment and over the life of the loan. This helps protect borrowers from large payment increases.

ARMs can be beneficial for some borrowers, like those who plan to move before the rate adjusts. But borrowers need to be aware of the risks if rates increase significantly. Understanding how ARMs work and reading the loan terms carefully is important.

Types of ARMs

There are several main types of adjustable-rate mortgages (ARMs) that differ based on the length of the fixed introductory rate period and how frequently the rate adjusts after that.

5/1 ARM

A 5/1 ARM has a fixed rate for the first 5 years, then adjusts annually after that. The first number indicates the fixed period, while the second number indicates the adjustment frequency. 5/1 ARMs are a very common type of ARM loan.

7/1 ARM

A 7/1 ARM keeps the initial rate fixed for 7 years, adjusting annually after that. The longer fixed-rate period provides more stability compared to a 5/1 ARM.

10/1 ARM

With a 10/1 ARM, the introductory rate is fixed for the first 10 years before adjusting once per year. The longer fixed period reduces risk but comes with a higher starting rate.

There are also 3/1, 3/3, and 5/5 ARMs with shorter fixed periods and more frequent adjustments. ARM loans can also adjust monthly rather than annually after the initial fixed-rate period.

Conforming ARMs meet the standards to be purchased by Fannie Mae and Freddie Mac. Non-conforming ARMs don't meet the requirements and have different guidelines. Most ARMs are conventional loans, but government-backed types like VA and FHA ARMs are also available.

Pros and Cons of ARMs

ARMs can offer benefits like lower initial rates compared to fixed-rate mortgages, but they also come with risks like unpredictable rate changes. Here are some of the key pros and cons to consider:

Pros

• Lower initial interest rate than fixed-rate mortgages. ARMs often start with a very low teaser rate that is fixed for the first few years. This makes the initial monthly payments lower.
• Potential for interest rate savings if rates remain stable or decline. If rates stay the same or go down during an ARM's fixed-rate period, you could end up paying less interest over the life of the loan compared to a fixed-rate mortgage.

Cons

• Risk of increasing interest rates and higher monthly payments. Once the fixed-rate period ends, your monthly payment can change annually based on rate adjustments. Rates may increase significantly over the life of the loan.
• Unpredictability and lack of payment stability. It's impossible to know exactly what your future monthly payments will be with an ARM, making budgeting difficult.

Is an ARM Right for You?

Deciding between an adjustable-rate mortgage (ARM) and a fixed-rate mortgage depends on your unique financial situation and goals. Here are some key factors to consider when determining if an ARM is the right choice:

1. Plans to move or sell the home within a few years - ARMs tend to have lower initial rates, so they may make sense if you won't be keeping the mortgage long-term. You can take advantage of the lower rate in the short term without the risk of higher payments down the road.
2. Future income uncertainty - ARMs carry the risk of increasing payments if rates go up. If your income is stable and likely to rise, this may not be as concerning. But if your income could decrease or fluctuate, a fixed rate provides reliable payments.
3. Risk tolerance - How comfortable are you with uncertainty and taking on risk for potential savings? ARMs involve more risk and unpredictability than fixed rates. If you want payment stability, a fixed rate may suit you better.
4. Ability to afford higher payments - Look at the maximum potential payment under the ARM terms, and make sure you have room in your budget to accommodate it if rates increase.

An ARM can offer advantages for some borrowers, such as those who plan to move soon or can manage unpredictable payments. But carefully consider your unique situation before choosing an ARM over a fixed-rate loan.

How to Qualify for an ARM Loan

To qualify for an adjustable-rate mortgage (ARM), you'll generally need to meet similar requirements as other types of mortgage loans. Here's an overview of key qualifications:

1. Credit score: Most lenders require a minimum credit score between 620-640 for approval of an ARM, but a higher score of at least 720 will get you better terms. Your credit report and history will be reviewed.
2. Income: Documented proof of stable income is required to qualify for an ARM. Many lenders look for at least 2 years of employment history in the same field. Self-employed borrowers may need more documentation.
3. Down payment: Typically 20% is recommended for an ARM to get the best rates, but some lenders may offer loans with as little as 3% down. The more you put down, the better.
4. Debt-to-income ratio: Your total monthly debt payments, including the ARM, usually cannot exceed 43% of your gross monthly income to qualify. Some lenders may allow up to 50%.
5. Home appraisal: The property will be professionally appraised to ensure its value matches or exceeds the loan amount.
6. Documentation: Pay stubs, tax returns, bank statements, and other paperwork may be required to verify your income, assets, employment, and creditworthiness.

Meeting these standard ARM qualification guidelines is key for approval. Be sure to shop around with multiple lenders to compare options. Pre-approval can also strengthen your offer when buying a home. LendingTree has more details on qualifying for an adjustable-rate mortgage.

ARM Rates and Rate Caps

ARM rates are determined based on an index rate plus a margin set by the lender. Common indexes used include the U.S. Treasury securities rates, LIBOR, and the 11th District Cost of Funds Index.

The initial interest rate is fixed for a set period, often 5 to 10 years. After the fixed-rate period, the interest rate adjusts periodically based on the index rate at that time plus the margin.

ARM loans have periodic and lifetime interest rate caps that limit rate increases:

• Periodic caps limit the amount the interest rate can adjust at each change - often 1% to 2%
• Lifetime caps limit the maximum interest rate over the life of the loan - often 5% to 6% above the initial rate

For example, a 5/1 ARM with a 2% periodic cap and 6% lifetime cap based on a 4% initial rate could adjust as follows:

• Year 1-5: Initial fixed rate of 4%
• Year 6: Adjusts to 5% (1% increase)
• Year 7: Adjusts to 6% (another 1% increase)
• Year 8+: Cannot exceed 10% (lifetime cap)

The rate caps protect borrowers from dramatic payment increases while allowing rates to adjust with the market.

Refinancing an ARM

Refinancing an adjustable rate mortgage (ARM) involves taking out a new loan to replace your existing ARM loan. This allows you to take advantage of lower interest rates or switch to a different type of mortgage, like a fixed-rate loan [1].

There are a few key pros and cons to consider when refinancing an ARM:

Pros:

• Can lock in a lower fixed interest rate if rates have fallen [2]
• Avoid interest rate spikes if your ARM is adjusting soon
• Switch to a fixed-rate loan for stability and predictability
• Reduce your monthly payments by getting a lower rate
• Shorten your loan term to pay off mortgage faster

Cons:

• Closing costs to refinance can be expensive (2-5% of loan amount)
• Starting over with a new loan term and payments
• Loan prepayment penalties may apply if refinancing early

The best time to refinance an ARM is when you can get at least 1% lower than your current rate. It also helps if you plan to stay in the home long enough to recoup refinancing costs [3]. Evaluate your break-even point and aim for when rates hit a relative low.

Adjustable Rate Mortgage FAQs

Adjustable rate mortgages (ARMs) have some key differences from fixed-rate mortgages that lead to common questions for potential borrowers. Here we address some frequently asked questions to provide guidance on terminology, comparisons, and deciding if an ARM is right for you.

What is the difference between an ARM and a fixed-rate mortgage? The interest rate on a fixed-rate mortgage remains the same for the entire loan term, while an ARM has an interest rate that adjusts periodically based on an index. ARMs offer lower initial rates but carry the risk of increasing payments over time [1].

How often do ARM interest rates adjust? This depends on the specific ARM loan. Common adjustment periods are every 6 months, annually, or every 3, 5, 7, or 10 years. The ARM will specify the length of time between rate changes [2].

What factors determine how much my rate can increase? ARM rate adjustments are limited by caps that restrict how much they can change per period and over the loan's lifetime. Know the caps before committing to an ARM [3].

Should I get a 7-year or 10-year ARM? The longer the initial fixed-rate period, the more payment stability you’ll have. But a shorter term often has a lower rate. Consider your budget and plans to move before deciding.

How do I compare ARM offers from different lenders? Look at the initial rate, annual and lifetime caps, credit requirements, and fees. Get multiple quotes to find the best overall value based on your situation.

Can I refinance my ARM later? Yes, you can refinance an ARM into a new fixed-rate or adjustable-rate mortgage. The timing depends on rates and your plans. Work with your lender to discuss options before your ARM adjusts.

Ask your loan officer any other questions you have about ARMs. They can provide custom quotes and guidance based on your financial situation and goals.

Current ARM Rates

Adjustable rate mortgages tend to have lower interest rates than fixed rate mortgages, especially during periods of declining interest rates. This allows borrowers to secure a lower rate initially with an ARM. However, ARM rates can fluctuate significantly over the life of the loan based on broader market conditions.

As of January 2023, average rates for popular 5/1 ARMs range from around 4.5% to 6% for well-qualified borrowers, depending on factors like loan amount, credit score, and location [1]. This represents a discount of 0.5% to 1% compared to average 30-year fixed mortgage rates. However, ARM rates have been rising steadily along with other interest rates.

The spread between fixed and adjustable rates can influence the relative demand for each product. When the difference is narrow, fixed rate mortgages tend to be more popular to avoid the risk of increases. As the gap widens, more borrowers may opt for ARMs to capitalize on the lower initial rates [2]. But it's important to weigh the short-term savings against long-term rate uncertainty.

Shopping around and comparing quotes from multiple lenders is the best way to find current ARM rates and determine if the discount from fixed rates merits the tradeoffs. Working with a mortgage broker can simplify the process [3]. Be sure to take the entire lifetime of the loan into account, not just the teaser rate.