Defining adjustable-rate mortgage (ARM)
An adjustable-rate mortgage (ARM) is a type of mortgage loan where the interest rate can change over time. The initial interest rate on an ARM is typically lower than that of a fixed-rate mortgage, but it can go up or down periodically, depending on market conditions. The initial interest rates remain fixed and changes occur later.
The mortgage’s reset rate is based on a benchmark or index and something called an ARM margin. The benchmark used until 2020 was the London Interbank Offered Rate (LIBOR) which phased out in June 2023. LIBOR has now been replaced by the Secured Overnight Financing Rate (SOFR). This benchmark is the rate at which major global banks lend to one another for short-term loans. Interest rates of an ARM change according to the market so you may either benefit or lose out as the rates change
ARM periods
There are two periods of an ARM: fixed and adjusted period. The period during which the interest doesn’t change is called the fixed period which can range anywhere from five to ten years. After this comes the adjusted period when the rate changes based on the benchmark.
Other factors influencing ARMs
ARMs are also dependent on the type of loan – conforming or non-conforming.
Conforming loans meet the standards of government-sponsored enterprises like Fannie Mae and Freddie Mac. These can be sold in the secondary market to investors.
Non-conforming loans do not meet these standards and cannot be sold as investments. There are also limits to the highest possible rate a borrower pays. Apart from this, interest rates are also determined by the individual’s credit scores. The higher the credit score, the lower the interest rates.
Types of ARMs
There are three types of ARMs:
- Hybrid ARM: These ARMs offer both a fixed and adjustable rate period. The interest rate is fixed for a specified amount of time and then begins to vary. Hybrid ARMs are expressed as two numbers with the first one being the number of years the rate remains fixed and the second being the number of years it will vary. For example, 10/5 ARM means that the rate will be fixed for the first ten years and then vary for the final five.
- Interest-only ARM (I-O): Here you only pay the interest on the mortgage for a fixed period of time (anywhere between three to ten years). After this, you need to pay both interest and the principal. The risk with this type of ARM is that the longer the interest-only period, the more you have to pay towards the latter end of the loan.
- Payment-option ARM: There are several payment options with this ARM. You can choose to pay both principal and interest, just the interest, or a minimum amount.
Things to consider before choosing an ARM
With ARMs, the most attractive feature is the low initial rate which can save you money and help you pay off more of your principal balance. This is a good option if you are planning to buy a home for a short period and then sell again later. You can use the money you save towards other expenses to set up your home. You also won’t have to consider a refinance because you’ll already be paying the best interest rates.
The unpredictable interest rates, however, are the biggest risk with this type of mortgage. If the market rates hike, you end up paying a lot more on the monthly mortgage payment. Many of these fluctuations may make it difficult for you to plan on your monthly budget.
If you are considering an ARM, it is advisable to do so only if you are planning to pay it off in a short period of time or if you expect to come into some money in the future either as income or inheritance.
