What Is An Adjustable Rate Mortgage?
Miranda Crace8-minute read
November 10, 2020
*As of April 20, 2020, Quicken Loans® isn’t offering conventional adjustable rate mortgages (ARMs).
If there’s one thing you can be sure of when you decide to buy a home, it’s that you will have choices, lots of choices: from the neighborhood you will call your own, to the house you choose to make your home, to how you will pay for it. One of those choices involves the type of mortgage you choose, and we’re here to help you decide whether an adjustable rate mortgage (ARM) is right for you.
Understanding What An Adjustable Rate Mortgage Is
An adjustable rate mortgage is a home loan with an interest rate that adjusts over time based on the market. ARMs typically start with a lower interest rate than fixed-rate mortgages, so an ARM is a great option if your goal is to get the lowest possible rate. However, your monthly payment can fluctuate after the initial period, which can make it difficult to budget. Understanding how ARMs work can help you be prepared in case your rate goes up.
The Difference Between Adjustable Rate and Fixed-Rate Mortgages
A fixed-rate mortgage can offer more certainty because it retains the same interest rate for the life of the loan. An ARM, on the other hand, may charge less interest during the introductory period, thus offering a lower initial monthly payment. If interest rates go down, ARMs can become less expensive than fixed-rate mortgages; but if rates go up, an ARM can become relatively more expensive.
How ARM Loans Work
ARMs are 30-year loans, meaning you’ll pay back the money you borrowed over a 30-year period, which is split into two periods:
- Fixed period: First, there’s an initial fixed-rate period (typically the first 5, 7 or 10 years of the loan) in which your interest rate won’t change.
- Adjustment period: Then, there’s a period in which your interest rate can go up or down based on changes in the benchmark. (More on benchmarks soon.)
For example, a 5-year ARM would have a fixed-rate for the first 5 years of the loan. After that, your rate could go up or down for the remaining 25 years of the loan.
How ARM Rates Are Set
After the introductory period, ARM rates reset according to the provisions of the loan.
The Role Of Benchmarks
The ARM loan contract names a rate benchmark from, for example, the U.S. Treasury or the Secured Overnight Finance Rate (SOFR), which will serve as the starting point of the reset calculation. U.S. Treasury and SOFR rates are among the lowest rates possible for short-term loans to their most creditworthy borrowers, generally governments and large corporations. From that benchmark, other consumer loans are priced at a margin, or markup, to these cheapest possible loan rates.
The margin applied to your ARM depends on your credit score and credit history, as well as a standard margin that recognizes mortgages are inherently riskier than the types of loans indexed by the benchmarks. The most creditworthy borrowers will pay close to the standard margin on mortgages, and riskier loans will be further marked up from there.
Conforming vs. Non-Conforming Mortgages
For mortgages that conform to Fannie Mae and Freddie Mac rules, whatever the margin is on your mortgage at the start will remain the margin at reset too. Lenders can sell mortgages that they originate to these government-sponsored entities for repackaging on the secondary mortgage market if they conform to their rules. But beware! Although there are good reasons why borrowers may need a non-conforming mortgage, and most originators of these loans are reputable, many are not. If you’re considering a non-conforming ARM, read the fine print about rate resets very carefully and make sure you understand how they work.
One corollary to this is that FHA and VA ARMs are considered non-conforming according to the rules of Fannie Mae and Freddie Mac, but they have the full backing of the U.S. government.
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How Rate Caps Work
Rate caps are usually made plain in the name of a particular ARM product, and once you understand the format, you’ll understand how these loans are structured.
Let’s consider an ARM that would be referred to in the real estate lending industry as a 5/1 (2/2/5) product.
What Does The 5/1 Refer To?
The first set of numbers details the length of the introductory period and how often rate resets can occur after that. Thus, a 5/1 ARM has a fixed interest rate for the first 5 years of the loan and the rate resets once per year after that.
What Does The 2/2/5 Refer To?
The second set of numbers details the rate caps:
- Initial adjustment cap: The first “2” is the cap, or limit, on how much your first reset can adjust your interest rate. In other words, at the first reset, after the 5-year introductory period, your ARM may reset your interest rate by 2% in Year 6.
- Subsequent adjustment cap: The second “2” is the limit on how much your subsequent rate resets can increase your interest rate. Generally, 2% is the standard subsequent adjustment cap. That means that in Year 7, your interest rate may rise again by as much as 2%.
- Lifetime adjustment cap: This is the cap that tells you how much the interest rate may increase in total over the lifetime of the loan. In our example, in Year 8 and thereafter, the interest rate can only increase by 1% total: 5% (total lifetime cap) - 2% (Year 1 adjustment) - 2% (Year 2 adjustment) = 1%
Most ARMs offer a 5% lifetime adjustment cap, but there are higher lifetime caps that could ultimately cost you much more. If you’re considering an ARM, make sure you completely understand how rate cap quotes are formatted and how high your monthly payments could get if interest rates climb.
Who Should Consider An ARM?
Most people like certainty and, especially with today’s low interest rates, opt for fixed-rate mortgages.
However, for some home buyers, particularly those who move often or are buying starter homes, ARMs may make more sense. If you’re not buying your forever home, then buying a house with an ARM and selling it before the fixed-rate period ends can mean a lower mortgage payment.
Of course, there is always the risk that you won’t be able to sell the house before your rate adjusts. If that happens, you may want to consider refinancing into a fixed-rate or a new adjustable rate mortgage. However, you’re still running the risk that interest rates will have increased at that point.
Adjustable Rate Mortgage FAQs
Are There Limits On How High ARM Interest Rates Can Go?
Conforming ARMs have lifetime rate caps that offer borrowers some predictability with respect to how often their interest rate changes, how much it can rise in the first year and again in the second year, as well as a total interest increase over the lifetime of the loan.
My Lender Talks About Basis Points. What Are They?
In real estate, the loan margin is often discussed in terms of basis points, which is the margin percentage multiplied by 100. For example, a real estate professional would likely refer to a 3% margin as 300 basis points above the benchmark.
Can We Convert Our ARM To A Fixed-Rate Mortgage?
Let’s say you love what you thought would be your starter home and have decided you want to stay there indefinitely. If you have a convertible ARM, it contains a provision that grants you this option. However, if you are considering an ARM now, be aware that it will cost you more upfront, which may defeat the whole point of choosing the ARM to begin with.
With that said, even if your loan doesn’t contain a specific conversion clause, you can refi into a fixed-rate loan if you qualify.
Get Started: Deciding Whether An ARM Loan Is Right For You
Whether to choose an adjustable rate mortgage is just one consideration when purchasing a home. Today, the United States is experiencing a period of very low interest rates, so it’s important to weigh your options and decide whether an ARM is the right choice for you. As of this writing, any discount you would get for taking an ARM isn’t worth giving up the certainty of fixed rates for most people.
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