An adjustable rate mortgage (ARM) is a home loan where the interest rate fluctuates periodically according to an index. These loans usually offer lower initial rates than fixed-rate mortgages and come with various features tailored towards both lenders’ and borrowers’ preferences.
ARMs can be a good option for homeowners who desire the security of a fixed-rate loan but are uncertain how long they’ll stay in their homes or how much money to spend. However, these loans also carry risks if the homeowner doesn’t refinance or sell before the introductory fixed-rate period ends.
The ARM process begins with a low initial fixed rate that typically lasts three, five, seven or 10 years. Thereafter, your interest rate and payment adjust periodically at predetermined intervals until either you sell your home, refinance your loan, or pay off the loan in full.
On an ARM label, such as 2/28 or 5/1, you’ll see how often the interest rate adjusts. This could be every six months to annually.
How It Works
ARM mortgages use an index plus the lender’s margin to calculate a loan’s indexed rate. This includes both the margin and underlying market rate, which is usually a prime lending rate published by major banks.
Some ARMs provide deeply discounted “teaser” rates during the initial years of a loan, which can significantly reduce your monthly payments. However, you may experience a large surprise later when the margin rate is added back into the calculation.
An ARM loan may not be suitable for those who do not meet the qualifications for fixed rate loans or have poor credit scores. According to Fannie Mae, lenders will only consider you for an ARM if your credit score is 700 or higher and there are no other liens on your property.
According to Kevin Parker, vice president of field mortgage originations at Navy Federal Credit Union in Washington D.C., if you qualify for an ARM your initial rate will be capped at around 2% after the initial period ends and subsequent rate adjustment periods require at least 2 percentage points of additional interest payment.
Your monthly payments may adjust gradually as the loan adjusts based on changes to the index. While these shifts may differ from month to month, the overall effect on your mortgage payment is usually positive.
Arms also feature rate caps that limit how much interest rates can rise over the loan’s lifespan, so be sure to thoroughly review your mortgage estimate or request a copy from the lender before you apply.
When comparing ARMs, consider the initial rate and fixed-rate period (the number of years the introductory interest rate is fixed). The longer this introductory rate period lasts, the better.
The lower the initial rate, the less risky an ARM is for both lenders and you. However, if you plan to stay in your home for several years or don’t plan to sell or refinance anytime soon, then it may not be worth considering.