An adjustable rate mortgage (ARM) is pretty much exactly like it sounds. It’s a type of mortgage loan that doesn’t have a fixed interest rate.
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The interest on an ARM loan fluctuates depending on a particular index and the margin that’s added to it. An index is a market-based interest rate determined by a neutral party. The margin is pre-determined percentage points that are added to the index.
Index + Margin = ARM interest rate
The ARM will have an initial rate for a specified period, which makes it more like a fixed rate mortgage in the first few years. Then at preset intervals the mortgage interest will be adjusted and the monthly payment will change. For example, a 5/1 ARM is very common. This means for the first 5 years the interest rate remains the same and then it’s adjustment once a year for the life of the loan.
That may sound too unpredictable for some people’s liking, but an ARM can be a smart financial tool in some situations.
The Advantages of an Adjustable Rate Mortgage
- Initial interest rate is often lower than fixed rate loans.
- ARMs can have a lower monthly payment at the beginning of the loan.
- Monthly payments may drop further if the index falls.
The Disadvantages of an Adjustable Rate Mortgage
- Not as predictable as a fix rate mortgage.
- Monthly payments could increase.
- The monthly payments may never go lower even if interest rates drop.
- Negative amortization is possible. That means you could end up paying more than the actual mortgage amount.
- As with all loans, watch out for early payoff penalty fees.
Why You Might Want to Consider an ARM Loan
Most homebuyers are going to opt for the reliable fixed rate mortgage. But there’s one instance where an ARM is likely worth the risk. If you only plan to own the home for a few years (or the length of the initial rate period) then an adjustable rate mortgage may be even more affordable than a fixed rate mortgage.
Another instance when an ARM can make sense is when the buyer expects their income or investments to increase in the future. In that scenario the buyer is somewhat certain they’ll be able to handle the higher payments if interest rates increase.
Questions to Ask Before Getting an Adjustable Rate Mortgage Loan
- How long will the initial interest rate period last?
- What type of interest rate can I expect after the initial period?
- How often will the interest rate adjust?
- What is the margin?
- What are the interest rate caps? Periodic? Lifetime?
- What is the low rate on the loan?
- Are there any early payoff penalties?
- What index is used to adjust the rates?
When in doubt, buyers should always seek the help of a financial specialist to get their questions answered.