The preferred mortgage product among most home buyers is the fixed-rate mortgage. However, the adjustable-rate mortgage (ARM) is another option for financing the purchase of a home. Here’s a quick primer.
What is an ARM?
The biggest difference between an adjustable-rate mortgage and a fixed-rate mortgage is that with an ARM, your interest rate will change after a certain period. With a fixed-rate mortgage, as discussed in a previous First Timer Primer, your interest rate is locked in and your payment will be the same every month for the duration of the loan.
As the name suggests, adjustable rate mortgages adjust. After an initial interest rate period, your lender will determine a new interest rate periodically, using calculations based on a measure of interest rates — like the constant maturity Treasury index, the Cost of Funds Index, or the London Interbank Offered Rate.
The lender adds a set number of percentage points, or “the margin,” to the index rate to determine your interest rate. The margin is quoted to you when you are choosing a loan and is usually constant. The adjustment period, or the period of time between rate changes, can vary from every month, to every year, to every five years.
An ARM is a bit of a gamble: if interest rates seem to be dropping, getting an ARM instead of a fixed-rate mortgage could mean that you’ll pay less in interest overall. But if rates go up, you’ll end up paying more. In return for taking on a bit of risk, lenders often offer a lower interest rate for the initial period.
How much can the rate adjust?
There are a couple cap structures with an ARM that keeps the rate from swinging too wildly: one cap limits how much your interest rate can change in one year, and another limits the maximum interest rate you will pay over the life of the mortgage.
Who might be interested in an ARM?
Because ARMs often initially have a lower interest rate than a fixed-rate mortgage, if someone knows they will only be staying in their home for a couple years, an ARM might be worth considering.
During these times of historically low interest rates, most people opt for a fixed-rate mortgage. But ARMs have been prevalent in the past when interest rates were higher.