Understanding ARMs - The Basics of How ARMs Work

Understanding ARMs - The Basics of How ARMs Work

An adjustable rate mortgage (ARM) is most simply defined as a home loan with an interest rate that can go up or down over time. Part of the rate is typically based on a broader measure of interest rates, called an index. Like any other loan, the initial agreement spells out the terms, so you should have a clear understanding of all the details before you make a decision.

Some of the factors you should consider when evaluating an ARM include the initial rate, the initial rate period, and the adjustment period.

We'll use the example of a lender offering a customer a "5/1 LIBOR ARM at 3.25% with 2/2/5 caps."

What is the Initial Rate and Period?

The interest rate that you secure when you first get an adjustable rate mortgage is the initial rate. In many cases today, the lender may offer a fixed rate for a period before the adjustment period begins. PennyMac, for example, offers adjustable rate loans with 3, 5, 7, and 10 years of an initial fixed rate. This type of hybrid ARM offers a period of predictability for the initial period, making it a desirable option for certain types of home buyers.

Example: In our example, the initial rate on the loan is 3.250% for the first five years.

What is the Adjustment Period?

The adjustment period is the length of time that your interest rate will remain unchanged, once the initial period is over. For example, an ARM that specifies a recalculation of your mortgage interest rate at the end of each year has an adjustment period of one year. During this time, your interest rate will remain the same, but it may change from year to year depending on variations in the market index.

Example: In our example, after five years the interest rate can adjust once a year (the 1 in the 5/1).

How are Adjustments Made?

Although the specific details vary depending on the lender and your loan terms, interest rate adjustments often reflect the changes in the market index your loan uses. Many loans today are based on the London Interbank Offered Rate (LIBOR). If the market index increases, your interest rate will also likely increase. On the other hand, if the market changes favorably, your rate might decrease accordingly.

Example: In our example, the annual rate adjustment in our example loan is based changes in the common (LIBOR) index.

Are Interest Rates Capped?

Many ARMs specify the maximum amount of each adjustment and on how high your interest rate can go over the life of the loan. In our example, the 5/1 ARM has 2/2/5 caps. This means that at the first adjustment, the interest rate cannot go up or down more than 2%. The second 2 represents every adjustment after the first one. From the second adjustment to the end of the loan, the annual adjustment can't go up or down more than 2%. The last digit in the caps, the 5, represents the lifetime ceiling adjustment.

Example: In our example, the interest rate can never go higher than 5% above the initial rate (3.25% + 5% = 8.25%)

When Should You Consider an ARM?

Because of the unpredictable nature of ARMs compared to a fixed-rate mortgage, you should prepare for a higher interest rate in the future. However, the initial rate for an ARM is often relatively low, so this type of loan can be a good fit in the following cases:

Brief period of ownership - If you plan to buy a home and resell it relatively quickly, you can take advantage of the lower initial rate. This also applies if you plan a mortgage refinance. In our example loan, a buyer planning on staying in the home five years or less may worry less about the adjustment period since they don't plan to own the home at the time of adjustment.

Steady income increase - If your career trajectory is likely to include a steady or predictable increase in income, you can plan for potentially higher rates in the future.

Long-term plan for rate increase - Even if you can already afford a higher initial rate now, an ARM allows you to save during the initial rate period so you can apply those savings in other ways. In our example, if the borrower is able to afford the monthly payment at 8.25%, they can enjoy the monthly payment savings from the lower initial rate, putting the money to other uses.

Risk tolerance - If you believe that the market is likely to shift in favor of lower interest rates, an ARM is a good choice, but only if you are able to pay the full interest rate If you are considering an ARM or would like to learn more, the Federal Reserve has provided the Consumer Handbook on Adjustable Rate Mortgages (ARM) as a reference tool that includes a checklist to help you compare mortgages.