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What is an Adjustable-Rate Mortgage (ARM)?

This week we’re continuing with a series of deeper dives into the four most popular mortgages in the US. We’ve already covered FHA loans and conventional loans. Today, we’re going a little deeper into adjustable rate mortgages (ARMs).

ARMs are mortgage loans that start with a low introductory rate for a time with periodic adjustments after that initial period. The introductory rate is so low when compared with other loans that is called a teaser rate. The introductory period is typically 3 to 10 years in length. The introductory period and the periodic adjustments are often quoted in the name of the loan. For example, a 5/1 ARM is an adjustable rate mortgage that has a 5-year teaser period and then would adjust every year on the anniversary after that. Another example is a 3/5 ARM, where the teaser period is 3 years and adjustments would occur every 5 years.

The adjustments to the interest rate could be positive or negative. The first adjustment though – after the teaser period – will increase the interest rate. These adjustments are tied to an index, like the rate on 1-year treasury securities, so if that rate has decreased since the last adjustment, the interest rate could go down. The opposite, of course, would also be true. The lender doesn’t just set the rate to equal the index because they need to make a profit on the loan. The adjustment then will include a markup for the lender’s margin, which is also part of the contract. For example, the 5/1 ARM might have an initial rate of 3.5% with adjustments tied to 1-year treasury securities with a 2% margin. This means that if 1-year treasury securities are paying 2.5% interest at adjustment time, the new interest rate would be 2.5% + 2.0% margin, or 4.5%.

Most ARMs also include an interest rate cap, so that if rates were to increase drastically on the index between adjustments, the borrower wouldn’t be hit with a painful increase. This cap might be somewhere around 7%. That interest rate could certainly be a shock coming from a 3.5% or 4.5% rate; however, it shouldn’t devastate the borrower.

It’s easy to get focused on the complexities associated with ARMs. After all, there are teaser periods, teaser rates, adjustment periods, margins, indexes, and rate caps to consider. If you focus on the big picture, an ARM makes sense if a borrower is planning on keeping a loan for only a short time because the teaser rate would be lower than the fixed rate. Additionally, if a borrower believes interest rates are going to decrease, they could always plan to start with an ARM and refinance before the first adjustment.

ARMs get a bit of a bad rap, however, there is a time and a place for them. If you’ve been considering buying a home and are curious about the different mortgage options available to you, hopefully this post has helped.

A high-level overview of the four popular types of mortgages can be found here.

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