Adjustable-rate mortgages (ARMs) are mortgage loan packages with interest rates that can be changed or “adjusted.” With ARMs, the interest rate is usually adjusted with an attached index rate (typically the LIBOR or U.S. treasury bill).
For most ARMs, there's an assessment period for the rate, wherein it's adjusted based on the rise or fall of the index rate. These periodic adjustments or “resets” happen during recurring intervals, as agreed upon between the lender and borrower.
"Adjustable-rate mortgages for home buyers who want to don't mind the risk of a variable rate, who can't obtain a fixed rate mortgage, or who may need or want a lower introductory rate."
The main advantage of ARMs is that they're usually cheaper than fixed-rate mortgages. This is because the borrower takes on the risks of the increasing market cost of borrowing. One clear disadvantage: if the index rate, federal funds rate, treasury bill, or LIBOR rises faster than your income, it would be much harder to afford the monthly payment.
The most popular of the adjustable-rate mortgage packages are the hybrid ARMs. These have a combination of a fixed rate and an adjustable rate. In a hybrid ARM, there's a fixed rate for a set term (3, 5, 7, or 10 years); after that term has passed, the rate is assessed on a recurring basis (typically annually).
These hybrid packages are perfect for home buyers who are looking for a short-term residence, expect an increase in household income, or simply want a period of lower monthly payments. However, the reset's often higher than the rate during the initial fixed period, so budgeting for ARMs can be slightly tricky!
Popular Hybrid ARM Loan packages
- 5/1 ARM – Fixed rate for 5 years, then the rate is assessed and adjusted annually.
- 7/1 ARM – Fixed rate for 7 years, then the rate is assessed and adjusted annually.
- 10/1 ARM – Fixed rate for 10 years, then the rate is assessed and adjusted annually.
Understanding Interest Rate Caps
To keep the margin between the initial fixed rate and the adjusted rates reasonable, lenders usually set interest rate caps. Interest rate caps mark the maximum amount that the rate can rise to per adjustment period, as well as over the entire loan term. These limits give the borrower a somewhat reasonable expectation of how much their monthly payments can increase. Interest rate caps have a couple of disadvantages:
- The most obvious downfall is that the first reset may very well be the largest increase, and dramatically raise your monthly payment as soon as the introductory period ends. If borrowers aren’t careful, they may be unable to afford these new, larger monthly payments, and then end up in financial trouble.
- The second (less obvious but equally important) downfall is that an interest rate cap applies to your loan, not the index interest rate. This means that during your loan term, you may reach the rate cap set by your lender, and the index rate could continue.
Would an Adjustable-Rate Mortgage Be Right for You?
Compared to the standard fixed-rate mortgage, there are many more factors to consider when it comes to adjustable-rate mortgages. Borrowers must think ahead toward the highly probable reality of a rate increase. That isn’t to say that a decreased rate is impossible—it's just unlikely given that hybrid ARMs start with comparably lower rates than many other home loans.
There are many borrowers who move or sell their homes before the adjustment period begins to avoid the rate increase. Obviously, this strategy won't work for home buyers who plan to live in the property for the long term. So, it's crucial to discuss interest rate caps and loan terms with a lender before entering into an ARM agreement.
Adjustable-Rate Mortgage Cons
- Monthly payments can increase after the introductory period
- Possible fee for prepayment (paying early)
- The interest rate cap may hit ceiling while the index rate continues to rise, causing negative amortization
Adjustable-Rate Mortgage Pros
- Lower rate during the initial rate period
- If the index rate drops, your interest rate also decreases
- Interest rate caps are set to prevent the rate from being raised too high
- Incentive for borrowers to relocate or pay the loan earlier during the introductory rate period