Can I convert my 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 granting you this option. However, if you’re considering an ARM now, be aware that it’ll cost you more upfront, which may defeat the whole point of choosing the ARM.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.

My lender talks about basis points. What are they, and how do they relate to ARMs?

In real estate, the loan margin is often discussed in terms of basis points, which are 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.

Are there limits on how high ARM interest rates can go?

Conforming ARMs have lifetime rate caps that offer borrowers some predictability. These caps operate with respect to how often their interest rate changes, how much it can rise from period to period, and a total interest increase over the lifetime of the loan.

What Is An Adjustable-Rate Mortgage (ARM) Loan?

Author:

Miranda Crace

Apr 12, 2024

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8-minute read

A man and women in kitchen discussing their finances.

Homeownership marks the start of a new chapter in your life. But before you can move into the home of your dreams, you must decide which type of mortgage will work best for your financial goals. One available option is an adjustable-rate mortgage. But what is an adjustable-rate mortgage and how does it benefit future homeowners?

Adjustable-Rate Mortgage Definition

An adjustable-rate mortgage (ARM), also called a variable-rate mortgage or hybrid ARM, is a home loan with an interest rate that adjusts over time based on the market. ARMs typically have a lower initial interest rate than fixed-rate mortgages, so an ARM is a money-saving option if you want the typically lowest possible mortgage rate from the start.

The low initial interest rate won’t last forever, though. Once the initial period ends, your monthly payment can fluctuate periodically, resulting in unpredictable monthly mortgage payments that are harder to factor into your budget.

Taking time upfront to understand how ARM loans work can help prepare you if your rate starts to climb.

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Adjustable-Mortgages Vs. Fixed-Rate Mortgages

Prospective home buyers can choose between an adjustable-rate mortgage and a fixed-rate mortgage. But what’s the difference between the two?

An ARM typically offers a lower, fixed interest rate during its introductory period than a fixed-rate mortgage, providing lower monthly mortgage payments at the start of the loan. After the initial period, changing interest rates will impact your monthly payment. When interest rates go down, ARMs can get cheaper. But if rates go up, ARMs can get more expensive.

A fixed-rate mortgage offers more certainty because the interest rate stays the same for the life of the loan. Your monthly interest and principal payment won’t change over the loan’s term.

How Does An Adjustable-Rate Mortgage Work?

ARMs are long-term home loans with two periods: a fixed period and an adjustable period.

Fixed period: During the initial, fixed-rate period, typically the first 5, 7 or 10 years of the loan, your interest rate won’t change.
Adjustment period: This period comes after the fixed period. Your interest rate can go up or down based on changes with the benchmark index tied to the ARM (more on benchmark indexes soon). ARM mortgages have a 30-year term, so the adjustment period is always the difference between the fixed period from 30 years.

For example, if you take out an ARM with a 5-year fixed period, the interest rate would be fixed for the first 5 years of the loan. After that, your rate would adjust up or down for the remaining 25 years of the loan.

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How Are ARM Rates Determined?

Various factors influence ARM loan rates. They include personal factors, like your creditworthiness, which affects the margin the lender sets upfront, and economic factors, like the current benchmark rate tied to your loan and its rate caps. To calculate your mortgage rate, a lender adds the current benchmark rate to your margin.

Margins

The margin is a fixed percentage a lender adds to the current benchmark rate to determine your ARM interest rate. Several factors determine your margin, including your credit score and credit history. With good credit, you’ll likely qualify for a lower margin. Riskier loans may have a higher margin to account for the possibility of a borrower defaulting.

Benchmark Rates

The benchmark index specified in an adjustable-rate mortgage agreement is a key factor in determining an ARM’s rate and is the starting point for future interest rate adjustments.

For example, your ARM may be tied to a benchmark rate like the U.S. Treasury or the Secured Overnight Financing Rate (SOFR). Both are typically among the lower and more stable benchmark rates.

Rate Caps

Fortunately for borrowers, ARMs often feature a critical safeguard: interest rate caps. A rate cap limits the maximum amount your interest rate can increase during each adjustment period and overall, based on your initial rate. This protects you from dramatic increases and makes adjustments more manageable on your wallet.

In the real estate industry, you may encounter a set of three numbers determined by a mortgage lender, such as 2/2/5. This series of numbers represents the details of your rate caps, each applying to a different phase of your ARM loan. The three separate caps are:

The initial adjustment cap: The first “2” is the cap on your interest rate during the first adjustment period. In other words, the new rate can’t increase by more than 2% after the introductory fixed-rate period ends.
The subsequent adjustment cap: The second “2” is the cap on future rate adjustments. Generally, 2% is the standard subsequent adjustment cap.
The lifetime adjustment cap: The “5” specifies how much the interest rate can increase in total over the life of the loan. In other words, the ARM’s interest rate can never exceed 5% more than your initial rate.

Most ARMs offer a 5% lifetime adjustment cap. Some lenders, though, may have higher lifetime caps, resulting in an even more expensive loan. If you’re considering an ARM, make sure you understand your lender’s rate caps and are ready to cover higher monthly mortgage payments if interest rates skyrocket.

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Conforming Vs. Non-Conforming ARM Loans

Beyond an ARM’s loan term, you’ll also need to decide between conforming loans and non-conforming loans as you explore your options.

Conforming ARM Loans

Conforming loans are mortgages that meet specific criteria that allow them to sell on the