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Adjustable-Rate Mortgage

What are the advantages of an adjustable-rate mortgage, and how does it work? An adjustable-rate mortgage (ARM) is a loan with an interest rate that varies throughout the duration of its life according to its assigned index.

In any case, the interest rates of an adjustable-rate loan will start at a fixed rate for a set period called the "adjustment period", and then gradually begin to fluctuate. Lenders will often give you the option to choose a length of time for the interest rates to remain fixed. This is why there are so many variants of an adjustable-rate mortgage.

Let's examine the advantages of an ARM and use an example to break it down in simple terms.

The Perks of Adjustable-Rate Mortgages

  • There are many hybrid ARM plans to choose from. Hybrid ARMs can be more consumer friendly because of their more customized approach. These types of mortgages can start out in a fixed-rate fashion and change into an adjustable-rate after a preset number of years. A 3/1 mortgage, for example, has a fixed interest rate of three years at which point it starts to adjust on an annual basis. 
  • ARMs have lower initial rates than fixed-rate mortgages (FRMs). Lower initial rates mean you can allocate the money you save from the get-go towards either a larger down payment, savings, a personal purchase, etc.
  • ARMs can offer more leeway than FRMs if you understand the risk associated with them. Interest rates can fall at any moment and possibly land you some equity, some loss, or break-even. It is commonplace and logically sane to assume that during times of a soaring interest rates, very low rates are likely to follow.
  • Interest rate caps limit how drastic the change in rates can be.
  • Ideal for homeowners willing to move to a new home before the loan period is over. If you're planning to stay in a home for only a few years, going for an ARM makes much more sense than an FRM. This is because you can use the lower rates of the fixed period and your refinancing freedom to gauge the risk associated with sticking to your current plan versus that of switching to another one before the adjustment period completes.
  • Homeowners can either refinance their existing ARM or switch to an FRM if current rates become unreliable.

To learn more about fixed-rate loans, click here.

The Components of Adjustable-Rate Mortgages

Let's use contrived figures to see how each component - which will be defined - influences the most important basic features of your adjustable-rate mortgage:

  • Initial interest rate: 4.75%
  • Margin: 2.75%
  • Index: 3.25%
  • Cap: 5/1/5%

1. The initial interest rate is usually the advertised interest rate. In this case, 4.75% is put into effect from the beginning of the loan period until the first adjustment period.

2. The adjustment period: Usually 1 to 5 years long, the adjustment period is the length of time the initial interest rate is subject to no changes. Once this period is over, the rate is reset and all following monthly payments are changed accordingly until the next adjustment period.

3. The index rate: After the first reset, the interest goes back to being fully-indexed. The indexes for lenders are issued by the US Treasury according to their regional cost of loan associations (i.e. COFI). In the case of some lenders, you may be given the option to choose your preferred major index that you think is more suitable for your situation. After the first adjustment period is over, your interest rate will reset and become fully indexed. You can find your fully indexed interest rate by adding your margin value with the index value: 2.75 + 3.25 = 6%.

4. Fully indexed rate: As done earlier, the fully indexed interest rate is found by adding the margin to the index value. This will be your new interest rate applicable to each one of your monthly payments after the adjustment period has passed.

5. Negative amortization occurs when the balance of the principal (loan amount) increases to compensate for the interest due on insufficient monthly payments. This happens by adding the remainder of unpaid interest to the principal. For more information on loan amortization, click here.

6. Conversion in an adjustable-rate mortgage allows you to switch to a fixed-rate plan only at predetermined time periods. Conversion can be contractually allowed by some lenders (ask if this interests you).

7. Prepayment is when you pay off the loan before the designated final date. Be careful and read the fine print as charges can be incurred in this situation.

8. Caps are designed to protect the borrower from interest charges that are too high to cover. The caps are disclosed during negotiations of the loan contract. To be able to read the caps assigned to your mortgage, recognize that they always come in the format as shown in the example above (5/1/5). The three digits refer to the three caps applicable throughout the life of your mortgage: the initial, and lifetime caps.

  • The initial cap: this is the rate of change that interest is allowed to reach after a reset at the end of the first adjustment period. The example figure's first digit - the number 5 - is the percentage range in which your interest rate is subject to change.
  • The periodic cap: the rate of change that interest is allowed to undergo within each periodic reset, whether it be every six months or every year. The example figure's second digit - the number 1 - is the percentage range in which your interest rate is subject to change between each reset.
  • The lifetime cap: the rate of change that interest is allowed to undergo throughout the life of the loan (i.e. 10, 15, or 30 years). The example figure's third digit - the number 5 - is the maximum percentage your interest rate is allowed to reach for the lifespan of the loan.

ARMs are more popular than fixed-rate loans because they're a lower risk to banks and lenders. Fixed-rate mortgages have unchanging interest rates regardless of the economic climate. This is why banks and lenders market ARMs better and push it more strongly. The borrower can be happier with the service because it is usually packaged with more benefits than other loan types.

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