What Is an Adjustable Rate Mortgage?

What Is an Adjustable Rate Mortgage?
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When shopping around for a mortgage, a borrower can choose which interest rate structure you want to have alongside the type of mortgage program you apply for and how much of a down payment you make. Most types of mortgage programs allow for either an interest rate that always stays the same (aka fixed-rate loan) or an interest rate that adjusts according to various terms (aka variable rate mortgage).

While going with the adjustable-rate mortgage (ARM) option offers some benefits, you should understand how the rate changes affect you. Use this guide on ARM loans to decide whether they sound right for you.

Basics of a Home Loan

By taking out a home loan, you work with your lender to determine the appropriate type of mortgage program (such as government-backed versus conventional), choose a term (usually ​15 to 30 years​) and get a particular interest rate on the principal portion of the loan balance. You also usually take out a loan that's equal to the price of the purchased home, plus any closing costs rolled in and minus down payment funds paid. However, some mortgages may allow for extra funds for renovating a property.

Several items are included in your monthly mortgage payment so that your money gets allocated to different areas. Besides paying part of the principal that reflects the remaining balance for the actual borrowed amount, you pay the interest your lender charges each month. You also have the escrow portion made up of the homeowner's insurance premiums and property taxes on the property. Private mortgage insurance (PMI) is another common part of a mortgage payment for people who make low down payments and don't take part in special mortgage programs.

Read More​: What Is PMI?

When taking out a mortgage, you agree to have the property used as collateral for the borrowed money, so making timely payments is crucial. While a single missed monthly payment might just mean a fee, missing for several months can lead to starting the foreclosure process during which the lender takes back the property and sells it to try to recoup the money for the loan. This means you should keep your lender informed of financial issues so they can help with alternative arrangements like a forbearance, temporarily reduced payments or loan modification.

Understanding Mortgage Rate Calculation

Since your mortgage interest rate reflects the cost you pay for borrowing, you need to understand how your lender calculates it so that you can take advantage of the lowest rates and minimize the interest paid overall. Lenders consider many factors, and they break down into two main categories – personal and market factors.

Personal factors include how good your credit score is, which property you buy, which type of mortgage program you choose, how much you put down on the loan, how long the mortgage loan term is and which interest rate type you decide on. For example, having a high credit score, putting ​20 percent​ down, buying a house in a low-cost area and going with a ​15-year​ term can help with lower rates. Keep in mind lenders offer different rates for the same types of mortgages, so it's important to inquire with multiple options and research thoroughly.

Along with these personal factors, economic conditions help determine whether interest rates rise or fall. For example, if the economy is down, fewer people have jobs and fewer people are shopping for homes, then banks want more people to borrow money, so interest rates tend to drop to encourage this. The federal funds rate, which is adjusted according to economic indicators like inflation and economic growth, has a key role in mortgage interest rate calculation as well as demand in the mortgage bond market.

Comparing Fixed Versus Adjustable Rates

Depending on the type of mortgage, you may get to choose between fixed-rate and adjustable-rate options. These differ in whether you can expect your mortgage interest rate to change over the course of your loan term, and this can mean either a more stable or more variable monthly payment. Your loan's disclosures should explain all about the interest rate system used, and you can discuss this with your lender when you start applying for mortgages.

With a fixed-rate mortgage, you're quoted an interest rate when you take out the loan, and that rate remains constant for the entire mortgage term. This offers more simplicity in that your mortgage payments are more predictable, but there's also a disadvantage with this type of interest rate option. For example, you might take out a mortgage in a time of higher interest rates, and then the rates drop a year or two later. Since you have a fixed-rate mortgage, you don't get to benefit from such changes, but the same would also apply to later rate increases that you'd avoid.

With an adjustable-rate mortgage (ARM), the interest rate you start with changes at some point depending on the loan's terms and the market. This means you usually start with a lower interest rate and then often get a higher rate a year or more later Your interest rate with this kind of mortgage can go down or up and at an interval that your lender sets. Your loan contract specifies a maximum rate that can help you with deciding if this kind of mortgage with more variable payments fits your financial situation.

Learning More About ARM Loans

As you explore ARM loans, your lender usually gives you some options such as 5/1 ARM​ and ​10/1 ARM. The first number reflects how long your initial interest rate will stay the same, while the second number reflects the frequency that your interest rate gets adjusted after the initial rate period. So, if you had a ​30-year 5/1 ARM loan​, then you'd have a stable interest rate for ​five years​ and then ​25 years​ during which the interest rate goes up or down annually.

Your lender uses both the index and margin to determine the interest rate you pay on an ARM loan. Lenders utilize a benchmark such as the London Interbank Offered Rate (LIBOR) or Constant Maturity Treasury (CMT) rate for the index, and then later they apply the margin amount stated in your loan terms when changes occur in the interest rate. Since the margin determines how much your ARM payment can change, you probably want to negotiate this with your lender.

When the lender does change your rate, the change is subject to different types of caps so that there are limits to how much your interest rate can change over the life of the loan. For example, there's an initial cap that limits the first increase, and this is usually not more than ​5 percent​ over the initial rate, and then there is a subsequent cap that usually tops out at ​2 percent​ and applies to future increases. Lastly, there's the lifetime cap that indicates the total increase that's allowed over the initial rate for the loan's lifetime, such as ​5 percent​.

ARM Loan Pros and Cons

The main benefits of ARM loans include the potential for lower rates plus some security when it comes to interest rate changes. Not only do these loans often have lower starting rates than you get with a fixed-rate mortgage, but you have the potential to see lower rates if adjustments occur and the market rates have dropped. Further, while rates can go up, you have the protection of the ARM loan's caps to offer some peace of mind in preparing for changes to your rates and mortgage payment.

However, this type of loan option does have more complexity and risk. You need to closely examine your loan terms for caps, rate changes and any prepayment penalties that could affect you. The biggest risk comes from the fact your rates can rise annually after the initial rate period, and this can cause issues if you get into financial trouble and the higher payments don't fit into your budget. So, having an emergency fund comes in handy as a safeguard.

Deciding on an ARM Loan

If you feel unsure about whether to choose an adjustable-rate mortgage or fixed-rate mortgage, it helps to consider both your preferences for loan payment amounts, interest paid over time and intentions for how long you expect to keep the home. You also need to think about whether you can afford potential increases in interest rates that might lead to a tighter budget as well as the outlook for where interest rates are heading in the future.

The Consumer Financial Protection Bureau (CFPB) recommends fixed-rate mortgages for people who want to keep a more stable mortgage payment and won't sell their homes for a long time. On the other hand, the CFPB advises that ARM loans can work well for those who plan to sell before the rate change applies and thus have a lower risk if the interest rates rise several years into the mortgage. ARM loans can also work for those with enough financial security to handle changing mortgage payments.

If you go with an ARM loan and later want to switch to a fixed-rate one, it may be possible through a refinance. However, this can come with closing costs and fees and possibly even a higher loan payment, so it may not help in a financial emergency. You also have to have enough value in your home ​and​ meet the financial and credit requirements to successfully refinance. So weigh the pros and cons of ARM loans carefully to prevent difficulties later.

Exploring ARM Mortgage Program Options

Along with choosing the period for which your ARM loan has the initial rate, you'll have options for different mortgage programs that may fit your needs. You can choose from conventional, Veterans Affairs (VA), jumbo and Federal Housing Administration (FHA) mortgages and choose the ARM option, while the U.S. Department of Agriculture (USDA) loan program doesn't allow for an adjustable rate.

These loans vary by down payment requirements, interest rates and credit standards. For example, FHA and VA loans have more flexible credit standards, and VA loans avoid PMI and a down payment. Conventional loans allow for down payments as low as ​3 percent​ but require better credit, while jumbo loans can help people with very good credit and higher incomes finance properties outside the loan limits for other options.

You can discuss your financial situation and preferences with a lender to locate suitable ARM loan options. They can also point you to state programs that can help with first-time home purchases and provide an estimate of the type of property you might afford with your income, debt and credit score.

Getting an ARM Loan

If you plan to use an ARM loan to buy a new house, you can start by talking to a lender early in the process and obtaining a preapproval. This step requires an application and submission of documentation, such as your proof of income and cash reserves, so the lender can do an initial assessment of your ability to afford the loan. They also look at your credit to assess eligibility for different mortgage programs and your potential interest rate. In the end, you should have an idea of your maximum possible loan amount and potential ARM loan terms.

The preapproval usually remains valid for ​90 days​, and you can get a letter that you submit with home offers to show that you've been working on financing. Once you have a successful home offer, you continue to work with the lender to answer questions, submit other requirements and eventually get to closing during which you provide your upfront costs and finish completing the paperwork needed to finalize the loan and move into your new home.