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Home Buying

What Is an Adjustable Rate Mortgage (ARM) and How Does It Work?

9 Minute Read

If you’re a homebuyer with a tight budget, the ARM (adjustable rate mortgage) might look attractive at first thanks to that low (initial) interest rate. You know, kind of like how your first crush caught your eye in middle school, but then you wised up once you realized their bathing habits were a little suspect?

When you look closer, you'll see why that interest rate is so low: the bank is shifting the risk of rising interest rates to you while betting (and not so secretly hoping) that interest rates will go up.

Trust us, it’s not a good bet for you. Here’s why.

What Is an Adjustable Rate Mortgage?

An adjustable rate mortgage may not seem like a bad idea at first. It even looks like it’ll save you money on your monthly payment compared to getting a conventional loan. What’s not to love about that?

But here’s the truth. An adjustable rate mortgage (ARM) is a type of mortgage that is just that—adjustable. That means, while you may start out with a low interest rate, it can go up. And up. And up. Which can really cost you an arm and a leg, pun intended.

When you finance your home with an ARM, the bank sets an initial interest rate that’s usually a point or so lower than the interest rate on a fixed-rate mortgage.

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The rate remains unchanged for a specific amount of time—usually a year, five years, or seven years—depending on the type of ARM. And then, the honeymoon is over.

After the too-good-to-be-true fairy tale ends, the lender can adjust your mortgage rate until it reaches the capped interest rate that’s been signed off on, or until they have used the max amount of times they can make changes to it.

Here’s where it gets even more messed up: Each time the rate adjusts (which is usually every year), your monthly loan payment changes. Since interest rates have been historically low lately, chances are, your lender will raise the rate to make up for rising interest rates. You’re welcome?

So ultimately, if you take out an ARM, you’re betting against yourself and your long-term financial security.

Understanding the Types of ARMs

Because mortgage lenders have so much flexibility when it comes to how they structure your mortgage, there are countless types of ARMs out there. Each one varies in its introductory period, interest rate, adjustment period, and other factors.

Figuring out the different kinds of ARMs means you’ll need to understand a few key terms they might throw at you (don’t worry—we’ve got you covered):

  • Initial Rate: this is the introductory interest rate the bank charges for a period of time, like a 3.25% introductory rate.
  • Introductory Period: how long your rate remains unchanged before the bank can make an adjustment. For example: a three-year introductory period.
  • Adjustment Period: how frequently the bank can adjust your interest rate once the introductory period is over and done.

Almost all adjustable rate mortgages are advertised as a series of two numbers . . . let’s say a 3/1 ARM. That would mean you have an introductory period of three years, and the bank can change the rate once a year. Great.

Basically, the first number tells you how long the introductory rate is going to be, and the second number shows how often the lender can adjust the rate.

But be careful. Banks also use different terms in their advertising, and it can get confusing. No, banks and mortgages companies trying to confuse you—say it ain’t so! Oh, yes. That’s partly because there isn’t one, go-to way lenders refer to ARMs.

Let’s break down a few examples of ARM advertising you might see:

ARM Advertised Description
5/1 ARM With 3.5% Introductory Rate An ARM with a 5-year introductory rate of 3.5% and an annual adjustment period each year afterward.

 

It seems pretty straightforward at first. A 5/1 ARM has two elements: a 5-year introductory period, and the lender can adjust the rate one time per year. Okay, cool. Got it.

But when it all boils down, this still leaves a lot of questions unanswered: How much can your lender increase your rate each year? What’s the absolute maximum change in your interest rate over the life of your loan?

These questions aren’t answered because, a lot of the times, you’re not going to like the answer. Here’s another example:

ARM Advertised Description
2/2/5 ARM With 3.5% Initial Rate for 3 Years An ARM with a 3-year introductory period of 3.5% and a 2% per-year adjustment window each year afterward, with a maximum of 5% adjustment up or down.

 

At first glance, it might look like this advertised ARM introduces a third part. But when you dig in a little, that’s not actually the case. This series of numbers refers to three completely different components from the 5/1 ARM in our first example.

Are you getting lost in the weeds yet? That’s kind of their point. But stick with us!

This loan’s first part is the amount the interest rate can change in the first year after the Introductory Period is over—so up to 2% in that year. The second number says how much the lender can adjust your interest rate each year afterward. The final number is the maximum percentage the loan can adjust over the total lifetime of your loan.

So here’s the deal: If your loan can change up to 5%, that means your maximum interest rate could go as high as 8.5% in as little as three years after your introductory period ends. Yikes!

That’s an insane interest rate when lenders are issuing fixed-rate mortgages with interest rates under 5%! But hold up, that’s still not as confusing or as crazy as ARMs can get. Here’s one last example you might come across:

ARM Advertised Description
5/1/5 ARM With 3.5% Introductory Rate An ARM with a 5-year introductory rate of 3.5% and an annual adjustment each year of up to 1%, with a maximum of five adjustments over the life of the loan.

 

With this ARM, the lender has (yet again) changed what a significant number means. This time, it’s the final number, which no longer gives the maximum percent the interest rate can change. Instead, it says the loan can only be modified five times in either direction.

Say what?  

We’re going to break this one down by taking a worst-case-scenario look at this loan:

Let’s say during your five-year introductory period, you’ve made all your payments and paid down your mortgage. But those gnarly interest rates have been climbing. So, the lender decides to pop you with another percent. And next year, they’ll do the same thing.

By year 10 of your loan, your interest rate is 8.5%! And that’s where it will stay until you’ve paid the mortgage off because they’ve adjusted you up for each of the 5 adjustments they can make. There are no more adjustments, even if the rates go back down to 4%.

Now that’s an expensive mortgage, and it’s one that’d be pretty silly to agree to.

With an ARM, you’ll never be able to fully know how much you’ll be paying each month and how much your home will ultimately cost you in the long run. How crazy is that?

That’s why ARMs are bad news—and why some mortgage lenders intentionally make understanding them so complicated!

How Are Rate Adjustments Made?

When you take out an ARM, you’re told the rate could change as time goes on. But what would trigger it? The answer is simple: the bank gets to decide based on the current mortgage market, or what they call the “index rate.” Your ARM paper work will let you know what index the bank will use.

Typically, lenders base rates on the London Interbank Offered Rate (LIBOR). That just means that if the LIBOR market index goes up, your interest rate also goes up. Womp-womp.

On the other hand, your banker will tell you that your rate might decrease if the market changes favorably. But note the key word right there: “might.”

There are other index rates that banks use to adjust your mortgage too. Some ARMs are indexed to the published Prime Interest Rate of the U.S. Federal Reserve. Others may rely on Fannie Mae and Freddie Mac to determine the rate of increase. Yep, it sounds confusing—and they kind of do that on purpose.

Bottom line? No matter what index your lender uses, you can count on one thing: the adjustment will usually be made to the benefit of your lender—not you. The rate may go down, but in today’s mortgage market, all trends are pointing up.

Why Fixed-Rate Mortgages Are Better

Skip the ARM and go the traditional, fixed-rate route. Fixed-rate mortgages give you more control over your money and shift the risk of rising interest rates back where it belongs—on the bank that loaned you the money. They’re making the profit, so they should take on the risks.

When you really stop to think about it, ARMs make less sense now more than they ever have before. Sure, that ultra-low introductory rate may save you a few bucks every month in the beginning.

But after the intro period ends, the lender gets to “evaluate” your mortgage and adjust the rate on you—costing you more money and blowing a hole in your budget.

That’s why you should get a fixed-rate mortgage instead. Locking in a long-term interest rate gives you the stability you need to plan long-term and the added benefits of saving money if interest rates go up.

Avoid the ARM trap and talk to the folks at Churchill Mortgage about the benefits of a fixed-rate mortgage. They’re the mortgage experts who will help you make the best decision for you and your family.

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Buy a House with an Agent Who Serves, Not Sells.

You need an agent who cares more about you than their commission check.
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