How does an Adjustable Rate Mortgage work?

ARM yourself with the facts about Adjustable Rate Mortgages

If you've worked hard on building a great credit score, it's a good idea to consider an Adjustable Rate Mortgage (ARM). Today's ARM options offer several benefits for homebuyers, including a lower initial interest rate than a traditional mortgage.

Before you choose an Adjustable Rate Mortgage, make sure you understand how they work.

What is an ARM?

ARMs typically cost less up front and are a good way to take advantage of lower interest rates. However, month to month payments can fluctuate.

ARMs are different in that you pay a lower interest rate for an introductory period—typically three, five, seven or 10 years—and after that, the interest rate can increase or decrease over time. The new rate is based on a market index, and the amount the rate can change each year and over the life of the loan (called the cap) is limited.

For example, a 30-year 7/1 ARM has a fixed interest rate for the first seven years, and then the rate can change annually. If the cap is described as 2/5, this means the interest rate can increase by up to 2% each year after the 7-year introductory period ends, and the maximum amount the interest rate can change over the life of your loan is 5%. So, in this example, if your introductory interest rate was 5%, the maximum rate you would ever pay would be 10%. Some ARMs may also limit the number of times the rate can change over the life of the loan.

Did you know? The index that is used to determine the adjustable part of an Adjustable Rate Mortgage’s interest rate is based on market factors. Popular mortgage indices include the London Interbank Offered Rates (LIBOR) and the MTA (Monthly Treasury Average).

What are the advantages of an ARM over a fixed-rate mortgage?

ARMs aren't for everyone, but they do offer benefits…

• The introductory rate for an ARM is usually lower than a traditional 30-year mortgage; lower interest rates mean lower monthly payments.
• Rates can go up, but they can go down, too. This allows you to take advantage of lower rates in the future without having to refinance.
• ARMs have a shorter fixed-rate term, which makes sense if you plan to sell the house in a few years.
• If you take the ARM but make a monthly payment as if it were a 30-year fixed-rate mortgage, you would be able to put the money you saved with the lower interest rate towards your principal each month, which allows you to build equity faster.

When should you consider an ARM?

An ARM may make sense when…

• There are significant rate differences between the ARM and a fixed-rate mortgage.
• You plan to sell your home before your interest rate adjusts.
• You expect your income to grow over time, which would allow you to make higher monthly mortgage payments if your ARM rate rises.
• You need a Jumbo loan; fixed rates for these types of mortgages are typically much higher than an ARM.

Did you know? About 6% of all mortgages are structured as Adjustable Rate Mortgages.

What should you look for in an ARM?

Before choosing an Adjustable Rate Mortgage, make sure to do thorough research…

• Learn about how much your ARM could adjust, when and how often. After the initial fixed period of the loan, most ARMs adjust their interest rate annually, but be sure to verify.
• Check to make sure that the adjustable portion of your ARM can go both up and down.
• Learn whether there’s a limit to the number of times your rate can adjust. For example, if your ARM is limited to five adjustments, it cannot be adjusted after the fifth change, even if rates drop.
• Look for an ARM that has no prepayment penalty.
• Calculate the maximum amount that your monthly mortgage could reach over the lifetime of your loan, to make sure you could still afford the payments.

Your lender will give you a Truth in Lending disclosure that covers all details of the loan; review it carefully and ask questions if you’re unsure about any of the terms.