Everything you need to know about Adjustable Rate Mortgage (ARM) Loans
What is an ARM?
The term ARM refers to an Adjustable Rate Mortgage. These home mortgages typically have initial fixed interest rate periods of 3, 5, 7, or 10 years followed by regular adjustment periods where the interest rate moves up or down with a specific index and are known as Hybrid ARMs. The most popular indices are the LIBOR (London Interbank Offered Rate), COFI (Cost of Funds Index), and the MTA (12-Month Treasury Average). These are a representation of the cost of debt at a given time and lenders use them to determine your adjusted pricing.
Additional ARM types include interest-only loans that allow you to pay just the interest accrued on the loan for a set number of years before switching to principal and interest payments. A pay-option ARM allows you to choose how you structure your payments over time, including interest-only, a portion toward principal, or full principal and interest.
How does an ARM work?
Adjustable rate mortgages are usually described by two sets of numbers that hint at the structure of the loan. A 5/1 ARM is fixed for the first 5 years of the loan and adjusts every 1 year after that; 7/1 and 10/1 ARMs follow the same structure with longer fixed periods. The loan itself will have an interest rate cap structure that’s described in order: initial adjustment cap – periodic adjustment cap – lifetime cap.
So, to continue the example, a 5/1 ARM with a 5-2-5 structure will be fixed for the first 5 years, then it can adjust for the first time by a maximum of 5% (up or down). Each subsequent year it can increase or decrease by a maximum of 2% - the periodic cap. Finally, over the entire life of the loan, it is capped from rising or falling by more than 5% above or below the initial rate. It is important to note that adjustments do have a floor or minimum interest rate that the lender will set based on their margins.
When is it beneficial to use an ARM?
It is most beneficial to take advantage of the low rates associated with the initial fixed-period of an ARM. This is easiest to do when you know how long you plan on owning the property. For example, if you’re going to retire and relocate in 5 years, then you know you’re not likely to keep your current home and mortgage longer than that, so it would make sense to consider a 5 or 7 year ARM. Even if you don’t have concrete plans to sell or refinance your home, The National Association of REALTORS® 2017 Profile of Home Buyers and Sellers notes that average tenure in a home is between 6 and 7 years historically.
When shouldn’t an ARM be used?
An adjustable rate mortgage should not be used if the fully adjusted payments will exceed acceptable debt-to-income limits. This scenario led to payment shock for borrowers when their low introductory interest rates were raised and it contributed to the housing crisis overall. With new legislation in place, lenders are required to qualify you based on the maximum possible payments on ARM loans. They will calculate the maximum adjustments over the life of the loan in order to ensure that there is no payment shock.