An “adjustable-rate mortgage” refers to 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 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, 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.
Hybrid Adjustable-Rate Mortgages
Most adjustable-rate home loans are hybrid programs, meaning they carry an initial fixed period followed by an adjustable period. They are also usually based on a 30-year amortization.
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 5 years fixed, and the remaining 25 years adjustable. Same goes for the 3/27, except only the first 3 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 5 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 5 year fixed period.
Adjustable-Rate Mortgage Interest Rate Caps
Adjustable-rate mortgages carry payment caps, which limit the amount of rate change that can occur in certain time periods. There are three types of caps:
Initial: The amount the rate can change at the time of the first variable period. 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, then 2% each subsequent period, 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!
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.
How an Adjustable-Rate Mortgage Works
Margin: 2.25 (won’t change)
Index: 4.75 (can go up and down)
Based on the two figures above, your fully-indexed rate would be 7.00%. 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 loan program. But as you can see, it plays a major role in the pricing of an adjustable-rate mortgage. Margins can vary by over 1% from lender to lender, so it can certainly affect you mortgage payment in a serious way.
Why Choose an Adjustable-Rate Mortgage?
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. A home equity line of credit is also considered an adjustable-rate mortgage because it’s tied to prime, and that can change whenever the federal funds rate changes.
But all adjustable-rate mortgages carry risk as the payments can change, sometimes sharply if the timing isn’t right. Learn more about all the advantages of adjustable-rate mortgages.
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.