The adjustable-rate mortgage (ARM) is a type of home loan with a variable interest rate. Initially, ARMs offer a fixed interest rate for a designated period. After this, the interest rate resets periodically based on a specific benchmark, incorporating a fixed ARM margin. Commonly, indexes such as the Secured Overnight Financing Rate (SOFR) are utilized.
Key Takeaways
- Adjustable-rate mortgages offer an interest rate that fluctuates based on a performance benchmark.
- Also known as variable-rate or floating mortgages.
- ARMs typically feature interest rate caps, limiting annual and lifetime interest payments.
- Ideal for homebuyers planning to retain the loan for short periods and can handle potential rate increases.
Grasping the Core of Adjustable-Rate Mortgages (ARMs)
Mortgages enable homeowners to finance property purchases. These loans are repayable within a set period, including both the principal amount and interest which compensates the lender. Mortgages differ significantly:
- Fixed-rate mortgages: Fixed interest rates and consistent payment amounts throughout the loan term.
- Adjustable-rate mortgages: Convenient choice wherein rates fluctuate with market conditions. Enjoy benefits if rates drop but face risks if rates increase.
Phases in ARMs
ARMs consist of two phases:
- Fixed Period: The interest rate remains unchanged, typically lasting five, seven, or ten years — the ‘intro’ or ’teaser’ rate.
- Adjusted Period: The interest rate resets based on an economic benchmark.
Conforming and Nonconforming Loans
- Conforming loans: Follow the criteria of government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac.
- Nonconforming loans: Fail to meet GSE criteria and aren’t accepted as secondary market investments.
Rate Caps
With capped rates, ARMs have maximum rates borrowers must pay. However, your credit score significantly impacts your interest rates.
Exploring Different Types of ARMs
Three forms of ARMs include Hybrid ARMs, interest-only (IO) ARMs, and payment-option ARMs.
Hybrid ARM
Hybrid ARMs merge fixed and adjustable-rate periods. They usually display two numbers — the length of the fixed period followed by the duration frequency of the adjustable rate. Example: A 5/1 ARM shows initial five years fixed, adjusts yearly thereafter.
Interest-Only (I-O) ARM
An interest-only ARM allows borrowers to pay just the interest for a predefined period (e.g., 3-10 years), followed by payments covering both interest and principal. Pros include reduced initial costs; cons involve potentially higher payments after the IO period ends.
Payment-Option ARM
This ARM offers several payment choices, including full, interest-only, and even minimal payments that may not cover the interest, resulting in negative amortization if principal repayment is postponed.
Weighing the Pros and Cons of ARMs
Advantages
- Low Initial Cost: Teaser rates mean lower initial payments compared to fixed-rate mortgages.
- Short-Term Financing: Ideal for short-term property investment or initial home buying.
- Fewer Hassles: No need to refinance during falling interest rates.
Disadvantages
- Interest Rate Variation: Payments may increase with rate hikes, potentially impacting your budget.
- Unpredictable Costs: The lack of predictability compared to fixed-rate loans can complicate budgeting.
- Complex Terms: Understanding features such as caps, indexes, and margins can be complicated.
How the Variable Rate on ARMs Is Determined
Post the fixed-rate term, ARM rates fluctuate based on a reference interest rate (the ARM index) plus a fixed margin. For instance, an index at 5% with a 2% margin adjusts to a 7% rate.
Adjustable-Rate Mortgage vs. Fixed-Interest Mortgage
Unlike ARMs, fixed-rate mortgages carry a constant interest rate for the loan’s lifespan, typically ranging from 10 to 30 years. While fixed-interest rates might initially be higher, they provide consistency by safeguarding against steep payment hikes.
Refinancing Benefits
Should interest rates dip, homeowners with fixed-rate mortgages can refinance to new, lower rates.
Is an ARM Right for You?
Perfect for homeowners planning to keep the mortgage short-term who can handle potential interest rate increment:
- Short Holding Time: Ideal for planned short ownership periods.
- Anticipation of Income Growth: Trusting positive income change in the future.
- Rapid Mortgage Payoff: Those expecting to pay off their mortgage swiftly.
Rate caps protect against unsustainable rate increases but monitor repayment sufficiency to avoid negative amortization problems.
Potential Downsides of ARMs
ARMs might not fit everyone. Favorable introductory rates offer initial attraction, but ARM’s unpredictability can lead to destabilizing fluctuating payments and financial hardship if rate caps aren’t in place.
How Are ARMs Calculated?
Upon fixed-rate term completion, ARM costs change with a chosen reference rate, supplemented by the ARM margin. Common benchmarks include the prime rate or the SOFR.
Historical Roots and Progress
Introduced in the 1980s, ARMs emerged post-Congress intervention in the 1970s followed by subsequent inconveniences prompting re-evaluation and retained implementation.
Conclusion
Whether you opt for a fixed-rate mortgage offering consistency or an adjustable-rate mortgage balancing initial costs with adaptable interest rates, understanding the details helps in making financially sound decisions. Consult with financial advisors to ensure ARMs are a fitting choice for your specific needs and plans.
Related Terms: variable interest rate, hybrid ARM, interest-only ARM, payment-option ARM, fixed-rate mortgage.
References
- The Federal Reserve Board. “Consumer Handbook on Adjustable-Rate Mortgages”, Pages 10–14 (Pages 13–17 of PDF).
- The Federal Reserve Board. “Consumer Handbook on Adjustable-Rate Mortgages”, Page 15 (Page 18 of PDF).
- The Federal Reserve Board. “Consumer Handbook on Adjustable-Rate Mortgages”, Pages 15–16 (Pages 18–19 of PDF).
- The Federal Reserve Board. “Consumer Handbook on Adjustable-Rate Mortgages”, Pages 16–18 (Pages 19–21 of PDF).
- BNC National Bank. “Commonly Used Indexes for ARMs”.
- Consumer Financial Protection Bureau. “For an Adjustable-Rate Mortgage (ARM), What Are the Index and Margin, and How Do They Work?”
- The Federal Reserve Board. “Consumer Handbook on Adjustable-Rate Mortgages”, Page 7 (Page 10 of PDF).
- The Federal Reserve Board. “Consumer Handbook on Adjustable-Rate Mortgages”, Pages 22–23 (Pages 25–26 of PDF).
- Federal Reserve Bank of Boston. “A Call to ARMs: Adjustable-Rate Mortgages in the 1980s”, Page 1 (download PDF).
