An “adjustable-rate mortgage” is a loan program with a variable interest rate that can change throughout the life of the loan. It differs from a fixed-rate mortgage, as the rate may move both up or down depending on the direction of the index it is associated with.
All adjustable-rate mortgage programs come with a pre-set margin that does not change, and are tied to a major mortgage index such as the LIBOR, COFI, or MTA.
Some banks and mortgage lenders will allow you to choose an index, while many rely on just one of the major indices for the majority of their loan products.
How an Adjustable-Rate Mortgage Works
Initial rate: 2.75% (won’t change during the initial fixed period of the loan)
Margin: 2.25 (won’t change ever)
Index: 1.25 (can go up and down)
Caps: 6/2/6 (regulates how much interest rate can go up/down)
Typically, an adjustable-rate mortgage will offer an initial rate, or teaser rate, for a certain period of time, whether it’s the first year, three years, five years, or longer. After that initial period ends, the ARM will adjust to its fully-indexed rate, which is calculated by adding the margin to the index.
To figure out what your fully-indexed interest rate will be each month with an adjustable-rate mortgage, simply add the margin to the associated index. You’ll be able to look up the current index price on the web or in the newspaper, and the margin you agreed to, which is usually found within your loan documents. You’ll also have to factor in payment caps to see when and how often your adjustable-rate mortgage actually adjusts.
Based on the two figures above, your fully-indexed rate would be 3.5%. In the illustration at the top of the page, we see a typical 5/1 ARM, which is fixed for the first five years before becoming annually adjustable.
During year six, the start rate (which had been fixed) disappears and the rate becomes the addition of the margin and index.
In year seven, we pretend the index increased by another .50%, raising your rate to 4%. In year eight, a big jump in the index increases your rate another two percentage points to 6%. This is where ARMs can get scary in a hurry.
Of course, this is just one scenario – the rate could also go down or stay the same, and even remain lower than a comparable fixed-rate mortgage. So it certainly goes both ways, it’s just that you’re taking a risk with an ARM as opposed to a fixed-rate product that never changes. That’s why you get a discount initially.
It is equally important to note both the index and margin when selecting a mortgage program from your bank or mortgage broker. Many consumers overlook the margin, or simply don’t even realize it’s an active component of the adjustable-rate mortgage.
But as you can see, it plays a major role in the pricing of an ARM. Margins can vary by over 1% from lender to lender, so it can certainly affect you mortgage payment in a major way.
Adjustable-Rate Mortgage Interest Rate Caps
The good news is that adjustable-rate mortgages carry adjustment caps, which limit the amount of rate change that can occur in certain time periods. There are three types of caps to take note of:
Initial: The amount the rate can change at the time of the first adjustment. In the examples above, it would be the initial change after the first 5 years of the loan.
Periodic: The amount the rate can change during each period, which in this case of a 5/6 ARM is every six months, or just once a year for a 5/1 ARM.
Lifetime: The amount the rate can change during the life of loan. So throughout the full 30 years, it can’t exceed this amount, or drop below this amount.
Typically, you might see caps structured like 6/2/6. This means the rate can change a full 6% once it initially becomes an adjustable-rate mortgage, 2% periodically (with each subsequent rate change), and 6% total throughout the life of the loan.
And remember, the caps allow the interest rate to go both up and down. So if the market is improving, your adjustable-rate mortgage can go down! But again, it would be limited by the caps, so your rate will never swing higher or lower more than the caps allow.
Additionally, many lenders put in interest rate floors that often coincide with the initial rate, meaning your rate will never go below its start rate.
Hybrid Adjustable-Rate Mortgages
Nowadays, most adjustable-rate home loans are hybrids, meaning they carry an initial fixed period followed by an adjustable period. They are also usually based on a 30-year amortization, meaning they last 30 years like fixed mortgages and are paid off similarly.
For example, you may see mortgage programs advertised like a 5/25 ARM or 3/27 ARM, just to name a couple. A 5/25 ARM means it is a 30-year mortgage, with the first five years fixed, and the remaining 25 years adjustable. Same goes for the 3/27, except only the first three years are fixed, and the remaining 27 years are adjustable.
You may also see programs such as a 5/6 ARM, which means the interest rate is fixed for the first five years, variable for the remaining 25 years, and will adjust every six months. If you see a 5/1 ARM, it is exactly the same as the 5/6 ARM, except it changes only once a year after the five-year fixed period.
Types of Adjustable-Rate Mortgages
There are many different types of adjustable-rate mortgages, ranging from one-month ARMs to 10-year ARMs. Obviously this represents quite a range of risk, so be careful when comparing different loan products.
1-month ARM: First adjustment after one month, then adjusts monthly
6-month ARM: First adjustment after six months, then adjusts every six months
1-year ARM: First adjustment after one year, then adjusts annually
3/1 ARM: First adjustment after three years, then adjusts annually
5/1 ARM: First adjustment after five years, then adjusts annually
3/3 ARM: First adjustment after three years, then adjusts every three years
5/5 ARM: First adjustment after five years, then adjusts every five years
5/6 ARM: First adjustment after five years, then adjusts every six months
7/1 ARM: First adjustment after seven years, then adjusts annually
10/1 ARM: First adjustment after 10 years, then adjusts annually
15/15 ARM: First and only adjustment after 15 years
As you can see, an ARM can give you as long as 10 years of fixed-rate payments, or as little as one month.
Note that there are other types of ARMs out there, and they may be advertised differently. For example, you might see a 2/28 ARM, or a 3/27 ARM, which are fixed for two and three years, respectively, before becoming adjustable.
How to Calculate an ARM Loan
Now that you’ve seen the many ARM loan options available, you might be wondering how to calculate an ARM adjustment. After all, there’s a chance you might face a rate adjustment if you hold onto your mortgage beyond the fixed period.
Fortunately, it’s not too difficult to calculate, you just need a few key pieces of information.
This includes the fully indexed rate (index+margin), the outstanding loan balance, and the remaining loan term.
For example, if you took out a 5/1 ARM with a rate of 2.5% and a loan amount of $200,000, the monthly payment would be $790.24 for the first 60 months.
After 60 months, the principal balance (remaining mortgage amount) would be $176,150.87.
Now let’s assume your margin is 2.25 and the index is 1.50. Together, that’s a new rate of 3.75%
We then have to apply that new rate of 3.75% to the remaining balance of $176,150.87 over the remaining term, which would be 300 months (25 years).
That results in a monthly payment of $905.65, at least for the 12 monthly payments during year six.
The loan will then re-amortize again at the start of year seven, and the monthly payment will be generated using the new outstanding balance and interest rate at that time. And so on down the line…
It’s good to know the math so you can compare your notes to your loan servicer’s to ensure everything is as it should be.
Why Choose an Adjustable-Rate Mortgage?
You might be wondering why anyone would get an adjustable-rate mortgage. Well, the main advantage of an ARM is the lower mortgage rate.
Most homeowners get into adjustable-rate mortgages for the lower initial payment, and then usually refinance the loan when the fixed period ends. At that time, the interest rate becomes variable, or adjustable, and the homeowner would likely refinance into another ARM, something fixed, or sell the home outright.
Some homeowners may also choose an adjustable-rate mortgage if the home is simply a short-term investment, or if they don’t plan on owning the home for more than five years.
For the record, a home equity line of credit (HELOC) is also considered an adjustable-rate mortgage because it’s tied to prime, and that can change whenever the federal funds rate changes.
But keep in mind that all adjustable-rate mortgages carry risk as the monthly payments can change, sometimes sharply if the timing isn’t right.
All that said, make an interest rate plan before you purchase a property. Decide what you want to do with the home in the next five years, and from there, you’ll be able to decide if an adjustable-rate mortgage is right for you.
Read more: Fixed-rate mortgage vs. adjustable.