First, let’s define precisely what an ARM loan is, otherwise known as an adjustable-rate mortgage.
An ARM loan is a mortgage with a variable interest rate. The initial interest rate will be fixed for a specific period. After that initial period is over, the interest rate on the outstanding balance will reset periodically, at yearly or monthly intervals depending on your loan terms.
What's in this article?
ARMs are frequently called variable-rate mortgages or sometimes floating mortgages.
ARM interest rates reset based on an index or benchmark plus an ARM margin. An ARM margin is a percentage added to the index by the lender after the initial rate period ends. This margin is set by your loan agreement and doesn’t change after closing.
Those are the basic facts. But, like every financial product designed to help you buy a home—the essential parts are in the finer details.
Today we’ll answer some of the most common questions about ARM loans, including:
- What are the components of an adjustable-rate mortgage?
- How does an ARM loan compare to a fixed-rate mortgage?
- And are there different types of ARM loans?
- What are the benefits of ARM loans?
Let’s break down these questions and see if an adjustable-rate mortgage is the right path for you.
What are the four components of an ARM loan?
The four components of an ARM are:
- Index
- Margin
- Interest rate cap structure
- Initial interest rate period
Once the initial interest rate period expires, a new interest rate is calculated by adding the margin to the index. A lender will let you know the margin at the time of the loan application. Margins vary from lender to lender.
As the index rises and lowers, so does your interest rate.
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How Adjustable-Rate Mortgages Work
With any mortgage, the borrower will have to repay the loan amount over a specific number of years (the life of the loan or loan term), plus interest.
The two types of interest rate mortgages
For interest rates, the two types of loans are
- Fixed-rate mortgages —The interest rate stays the same for the life of the loan
- Adjustable-rate mortgages—The interest rate fluctuates
As we mentioned, the rates on an ARM loan will typically be less during the initial introductory period, also known as the fixed-rate period. This gives you a lower monthly payment during this time. How long that time is will depend on the terms of your loan with the lender.
The adjustment period then takes over and rates will begin to adjust based on the index. Compared to a fixed-rate mortgage, the borrowing costs with an ARM loan are set at a lower rate during the initial period. But after that initial period, that first number interest rate could go higher or lower depending on market conditions and the cost of borrowing.
The reason for an interest rate
An interest rate compensates the lender for their work on the loan. It also mitigates the effects of inflation which will likely erode the value of the loan amount by the time of the final payment.
Types of ARM loans
Generally, ARM loans come in three types: hybrid ARMs, interest-only (IO) ARMs, and payment option ARMs.
Hybrid ARM
A hybrid ARM offers a mix of adjustable-rate and fixed-rate periods.
The mortgage lender will set the introductory rate, usually at a lower interest rate, for a fixed period during the initial period. After that, the interest rate will “float” or vary.
Typically, you’ll see these mortgages expressed like this: “2/28 ARM.” This example is of a 30-year hybrid ARM with an initial fixed interest rate period for the first two years. Then the ARM loan is subject to rate adjustments for the remaining 28 years.
Another example—let’s use a 10-year mortgage this time—might be a 5/5 ARM with a five-year fixed-rate period, followed by an adjustment period of five years.
Interest-only (IO) ARM
As the name suggests, an interest-only ARM loan means you’ll pay the interest rate amount on your adjustable-rate mortgage for a set period, around three to ten years. After the initial period ends, you’ll be required to pay both the principal and interest on the ARM loan.
Remember that your payments will be much lower for the first period but significantly higher during the latter period. Plus, the longer the initial period, the higher monthly payments will be during the second.
Payment-option ARM
This home loan comes with different payment options. These options generally include payments to cover the interest, both interest and principal, or minimum payments that don’t even cover the interest.
The advantage of this type of ARM is it frees up funds for other things like home repairs or perhaps buying furniture.
However, you must remember that the borrower owes the total loan amount, regardless of the payment schedule. Interest charges will be higher when the principal isn’t being paid. If only minimum payments are made, your debt amount might reach unmanageable levels.
Regarding eligibility, be sure to use a mortgage calculator or apply for pre-approval to find out what you might qualify for and what could be your monthly payments.
A pre-approval for a specific home will show items such as the purchase price, the type of loan program you choose, initial interest rate, the loan amount you’re likely to qualify for, your down payment amount, expiration date, and the property address.
Adjustable-rate mortgages versus fixed-rate mortgages
Fixed-rate mortgages (also called fixed-rate loans) have the same interest rate for the entire loan term. These mortgages will often have a higher fixed-interest rate than ARMs.
This difference makes adjustable-rate loans more attractive to borrowers interested in short-term savings.
However, a fixed-interest rate allows homebuyers to predict what monthly payments will be throughout the life of the loan. Conversely, ARMs are subject to interest rate changes that make payment amounts less predictable.
If interest rates fall, fixed-rate mortgage homeowners can opt to refinance, hopefully paying off their initial fixed-rate loan with a new, lower interest rate loan.
Benefits of adjustable-rate mortgages
ARM loans are considered a positive choice if you plan to keep the loan for the short term. The key to this plan is to handle the interest rate changes that occur in the meantime.
Many ARM loans include rate caps that limit the rate adjustment at any time or during the entire loan term.
Alternatively, some ARM loans have payment caps, limiting how much the monthly mortgage payment can increase.
The problem with this loan option is if the payment amount doesn’t cover the monthly interest, you’ll be at negative amortization. This term means the amount you owe could increase even though you’re making monthly payments.
Is an adjustable-rate mortgage right for you?
ARM loans can be a wise financial choice for homebuyers who plan to keep the mortgage for a limited time.
Loan officers at Compass Mortgage understand the importance of the life-changing milestone of becoming a homeowner. The relationship we have with borrowers sets us apart from other lenders.
We believe in treating every potential client with love and respect and will go to great lengths to make your homeowner’s dreams come true.
To find the best way to buy a home, reach out to our team today and get started on your dream home journey.