Everything You Need To Know About Adjustable Rate Mortgages (ARMs)

Introduction

Adjustable Rate Mortgages can evoke uncertainty, but when approached with the proper understanding and prudence, they can be a powerful tool for securing a home while potentially saving money. To determine if it's the right decision for you, simply analyze the numbers to evaluate the balance between risk and potential savings, a task made easy with our Ultimate Mortgage Analysis Tool.

Understanding ARMs

Before diving into ARMs, it's crucial to familiarize yourself with key ARM terminology, then gather the relevant information from your lender in order to crunch the numbers so that you can make an informed decision. We've compiled a list of terms you should know in our "ARMS Terminology" section below.

Situations Where Adjustable Rate Mortgages Make Sense

ARMs are not the right tool for every situation, however there are many different reasons why an ARM can be a better financial decision than a fixed rate mortgage. If you meet any of these situations, I would strongly consider the possibility of choosing an ARM:

  • Short-Term Ownership Period: If you plan on selling the house before the initial period is up (usually 5-7 years), or really your break-even point, an ARM could end up saving you money. Once you hit the break-even point, your ARM could start costing you money. Your actual break-even point is impossible to know and will vary depending on how your ARM ultimately changes at the end of each adjustment period, so it is a good idea to understand what your break-even is in a worst-case scenario.
  • Planning to Refinance: If you plan to refinance your mortgage before the initial period ends (or even your worst-case break-even date), an ARM could serve as a temporary financing solution. You could benefit from the lower initial rates prior to experiencing the potential rate adjustments.
  • Rapid Earning Growth Potential: Individuals and couples early in their career with an entry-level job and high likelihood of career advancement/growing their earning potential could benefit from an ARM since the lower starting rate usually associated with an ARM can allow for quicker entry into the housing market without stretching your budget. Risk from an ARM adjusting upwards at a future date is minimized in this situation since the higher salary should compensate for the rate adjustment.
  • Other Debts Ending: Similar to the situation where you are expecting rapid growth in your earnings, if you have debts that will be paid off prior to your first mortgage adjustment (think student loans, car payments, etc.), this with free up more money to allocate to potentailly increased mortgage payments later down the line, should your rate end up adjusting upwards. The lower ARM rate allows you entry into the housing market to start building equity now while knowing you will have a minimized level of risk later down the line.
  • Rapid Mortgage Paydown: Say your planning to aggressively pay down your mortgage. Maybe your plan is to pay it off in 10 or 15 years. So you get a 15 year fixed mortgage, right? Well, believe it or not, an ARM can often be less risky and accomplish your goal even sooner ‐ even while making the exact same monthly payment. It's significantly less risky than a shorter fixed mortgage since if you need to lower your payment, you can, whereas you are stuck with your payment with the 15 year. The initial rate is lower so you are building up more equity prior to the first adjustment,
  • ARM-Friendly Market Conditions: In certain market conditions, such as where ARM rates are significantly lower than those of fixed-rate mortgages, or interest rates are projected to go down, opting for an ARM could result in substantial savings over the life of the loan. You can often look at rate forecasts, at least in the short term, for various indexes, in order to get a better understanding of anticipated market conditions. Just beware – these are only projections and are therefore not guaranteed!

ARM Terminology

Adjustable Rate Mortgage (ARM): A type of mortgage loan where the interest rate can change periodically at set times, causing the monthly payment to fluctuate accordingly.
Example: A borrower may secure an ARM with an initial fixed interest rate for the first seven years, after which the rate adjusts annually based on whatever the current rate is of the associated index.

Index/Benchmark: A benchmark interest rate that serves as the basis for adjusting the interest rate on an ARM. When it is time for your ARM to adjust, a set percentage, known as the "Margin," is added to whatever the current rate is for the associated index to determine your new rate. Each ARM can be tied to a different index, so be sure to get this from your lender.

Margin: The fixed percentage added to the index rate to determine the new interest rate on an ARM. It remains constant throughout the life of the loan and is set by the lender based on factors such as credit risk and market conditions.

Initial/Base Rate: The starting interest rate applied to an ARM at the beginning of the loan term. This rate typically remains fixed for an initial period, after which it may adjust based on the terms of the mortgage.

Initial Period: Also known as the "Initial Fixed-Rate Period," it is the period at the beginning of the loan term during which the interest rate remains fixed. After this period, the rate may begin to adjust according to the terms of the ARM.
Example: In a 5/3 ARM, the initial period is for five years before the first rate change, and then it adjusts every three years thereafter.

Adjustment Periods: The frequency at which the interest rate on an ARM can change after the initial fixed-rate period expires.
Example: In a 5/3 ARM, the initial fixed rate is for five years and then it adjusts every three years (subsequent adjustment periods) thereafter.

Initial Rate Cap: A limit on how much the interest rate can increase during the first adjustment period after the initial fixed-rate period ends. This provides borrowers with protection against significant rate hikes immediately after the initial period.
Example: With 3/2/5 CAPS, a mortgage cannot increase or decrease by more than 3% for the initial adjustment.

Subsequent Rate Caps: Limits on how much the interest rate can increase or decrease during subsequent adjustment periods after the initial period. These caps provide borrowers with protection against large fluctuations in their mortgage payments.
Example: With 3/2/5 CAPS, a mortgage cannot increase or decrease by more than 2% for any adjustments after the initial adjustment.

Lifetime Adjustment Cap: The maximum limit on how much the interest rate can increase over the entire term of the loan. This provides borrowers with long-term protection against significant rate hikes, ensuring that payments remain manageable.
Example: With 3/2/5 CAPS, a mortgage cannot increase or decrease by more than 5% from the initial rate for the lifetime of the loan.

Floor Rate: The minimum interest rate that can be charged on an ARM, regardless of how low the index and margin indicate the interest rate should be. This provides lenders with protection against excessively low interest rates in fluctuating market conditions.

Conclusion

While ARMs offer advantages in certain situations, thorough research and understanding are paramount. While hopefully this guide has given you the jump-start you need to begin understanding ARMs, consultation with professionals and the use of resources like our Ultmate Mortgage Analysis Tool can empower you to make informed decisions aligned with your financial goals.