mortgages

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

9 Minute Read

An adjustable rate mortgage (ARM) is a type of mortgage where the interest rate you pay on your home periodically changes, which impacts your monthly mortgage payment. The interest rates you’ve probably seen advertised for ARMs are usually a little bit lower than conventional mortgages. But if you read the fine print, you’ll quickly learn the advertised rate is just the initial rate. Which means the rate can change. And it will likely change in one direction: Up!

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. The rate remains unchanged for an introductory period—usually a year, five years, or seven years—depending on the type of ARM. And then, as they say, the honeymoon is over.

After the introductory period ends, the lender can adjust your mortgage rate periodically until it reaches the capped interest rate authorized, or until they have used the max authorized number of adjustments.

Each time the rate adjusts (which is usually every year), your monthly loan payment changes. Since interest rates have been historically low in recent years, chances are, your lender will raise the rate to compensate for rising interest rates.

If you’re a homebuyer with a tight budget, the ARM might be attractive because of that low initial rate. But when you look closer, you learn why it’s so low: the bank is shifting the risk of rising interest rates to you while betting that interest rates will go up.

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When 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. 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:

  • 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 has ended.

Almost all adjustable rate mortgages are advertised as a series of two numbers, such as a 3/1 ARM. A 3/1 ARM means you would have an introductory period of three years, and the bank can change the rate once a year. So, the first number tells you how long the introductory rate is, and the second number indicates how frequently the lender can adjust the rate.

But banks also use different terms in their advertising, and it can get confusing. That’s because there’s not one, standardized way lenders refer to ARMs. It’s important to understand the various parts of this kind of loan, from the interest rate to the adjustment period. Some sources refer to these parts as “elements” and others as “components.”

To get a better understanding of an ARM, you have to break down the individual components of the loan and how lenders refer to them. Typically, the components of the loan are referred to by a sequence of numbers, like a 2/1/5 ARM. Each number signifies a different component. 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. However, this advertising leaves a lot of questions unanswered. How much can your lender increase your rate each year? What’s the maximum change in your interest rate over the life of your loan? These questions aren’t answered because, a lot of the time, 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.

In this example, you might think at first glance that the advertised ARM introduces a third component. But when you dig down a little, you’ll find that’s not the case. This series of numbers refers to three completely different components from the 5/1 ARM in our first example.

This loan’s first element is the amount the interest rate can change in the first year after the Introductory Period expires—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 of adjustment over the life of your loan. 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.

That’s an insane interest rate when lenders are issuing fixed-rate mortgages with interest rates under 5%! However, as we’ll see, that’s not as confusing or as crazy as ARMs can get. Here’s a final example:

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 specifies the maximum percent the interest rate can change. Instead, it says the loan can only be modified five times in either direction.

Let’s take a worst-case-scenario look at this loan. Throughout your five-year introductory period, you’ve made all your payments and paid down your mortgage. But interest rates have been climbing. 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%.

That’s an expensive mortgage, and it’s one you’d be foolish to agree to. With an ARM, you’ll never be able to fully determine how much you’ll be paying each month and how much your home will ultimately cost you in the long run. That’s why ARMs are bad—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 periodically. But what would trigger that change? 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 specify the method of determining what index the bank will use.

Typically, lenders base rates on the London Interbank Offered Rate (LIBOR). This sounds complicated, but it really just means that if the LIBOR market index goes up, your interest rate also goes up. On the other hand, your banker will tell you that your rate might decrease if the market changes favorably. But note the key word, “might.”

There are other index rates that banks use to adjust your mortgage. 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.

But regardless of what index your lender uses, you can count on one thing: the adjustment will usually be made to the benefit of your lender. The rate may go down, but in today’s mortgage market, all trends are pointing up.

Why fixed-rate mortgages are better

A traditional, fixed-rate mortgage gives you more control over your money and shifts 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 assume the risks.

ARMs make less sense now more than ever before. Sure, that ultra-low introductory rate may save you a few bucks every month in the beginning. But after the introductory period ends, the lender gets to “evaluate” your mortgage and adjust the rate—costing you more money and blowing a hole in your budget.

That’s why you should look into a fixed-rate mortgage instead. Locking in a long-term interest rate gives you the stability you need to plan long-term and the 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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