Adjustable-Rate Mortgages

Adjustable-rate mortgages (ARMs) differ from fixed-rate mortgages in that the interest rate and monthly payment can change over the life of the loan. ARMs generally have lower introductory interest rates compared to fixed-rate mortgages. Before deciding on an ARM, it is important to consider how long you plan to own the property and how frequently your monthly payment may change, due to an “adjustment” in the interest rate.

Why choose an adjustable-rate mortgage?

The low initial interest rates offered by ARMs make them attractive when interest rates are high, when homeowners only plan to stay in their home for a relatively short period of time, or when a homeowner is expecting a major rise in income. Homebuyers may find it easier to qualify for an ARM than a traditional loan. However, ARMs are not for everyone. If you plan to stay in your home long-term or are hesitant about having loan payments that shift from year-to-year, then you may prefer the stability of a fixed-rate mortgage.

Components of adjustable-rate mortgages

Adjustable-rate mortgages have three primary components: an index, margin, and calculated interest rate.

  • Index

The interest rate for an ARM is based on an index that measures the lender’s ability to borrow money. While the specific index used may vary depending on the lender, some common indexes include U.S. Treasury Bills and the Federal Housing Finance Board’s Contract Mortgage Rate. One thing all indexes have in common, however, is that the lender does not control them.

  • Margin

The margin, also referred to as the “spread”, is a percentage added to the index in order to cover the lender’s administrative costs and profit. Though the index may rise and fall over time, the margin usually remains constant over the life of the loan.

  • Calculated Interest Rate

Adding the index and margin together gives you the calculated interest rate, which is the rate the homeowner pays. It is also the rate to which any future rate adjustments will apply (rather than the “teaser rate,” explained below).

Adjustment periods and teaser rates

Since the interest rate for an ARM can change due to economic conditions, it is key to ask your lender about the adjustment period. Basically, “How often can my interest rate change?” Many ARMs have one-year adjustment periods, which means the interest rate and monthly payment is recalculated (based on the index) every year. Depending on the lender, longer adjustment periods are also available.

An ARM can also have an initial adjustment period based on a “teaser rate,” which is an artificially low introductory interest rate offered by a lender to attract homebuyers. Usually, teaser rates are good for 6 months or a year, at which point the loan reverts back to the calculated interest rate. Remember, too, that most lenders will not use the teaser rate to qualify you for the loan, but instead use a 7.5% interest rate (or calculated interest rate if it is lower).

Rate caps

Most ARMs have “caps” that govern how much the interest rate may rise between adjustment periods, as well as how much the rate may rise (or fall) over the life of the loan, as a protective measure for both the buyer and the lender. For example, an ARM may have a 2% periodic cap, and a 6% lifetime cap. This means that the interest rate will not be allowed to rise more than 2% during an adjustment period, or more than 6% over the life of the loan. The lifetime cap almost always applies to the calculated interest rate and not the introductory teaser rate. Some government loans, such as through the Veterans Administration, might have a 5% cap over the life of the loan.

Payment caps and negative amortization

Some ARMs also have payment caps. These differ from rate caps by placing a ceiling on how much your payment may rise during an adjustment period. While this may sound like a good thing, it can sometimes lead to real trouble.

For example, if the interest rate rises during an adjustment period, the additional interest due on the loan payment may exceed the amount allowed by the payment cap–leading to negative amortization. This means the balance due on the loan is actually growing, even though the homeowner is still making the minimum monthly payment. Many lenders limit the amount of negative amortization that may occur before the loan must be restructured, but it’s always wise to speak with your lender about payment caps and how negative amortization will be handled.