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An adjustable rate mortgage (ARM) is a type of mortgage in which the interest rate may change during the repayment period, changing the amount owed in monthly payments. Adjustable rate mortgages are less common than 15- or 30-year fixed rate mortgages, but many people who plan to refinance or sell their homes quickly choose an ARM in order to keep their interest rates down in the first few years.
- Definition of an Adjustable Rate Mortgage
- Calculating Adjustable Rate Mortgage Payments
- Pros and Cons of Adjustable Rate Mortgages
Definition of an Adjustable Rate Mortgage
Adjustable rate mortgages include all types of mortgages that tie the ongoing interest rate to a moving index published by the US Treasury or other financial institution. A typical ARM rate is made up of a variable index rate and a fixed margin added on top of the index. The size of the margin depends on your credit score and loan amount, but the indexes will rise or fall based on market conditions. For adjustable rate mortgages, lenders rely on several well-known indexes:
Popular Indexes for ARM Rates
ARMs allow lenders to pass on the risk of rising interest rates to their borrowers. The mortgage rate will rise (or fall) together with the relevant index. In return for the greater risk, borrowers receive a lower initial rate than a fixed rate mortgage of the same amount and duration. Most ARMs also guarantee that low rate for a fixed introductory period. For instance, a 5/1 ARM sets a fixed rate for the first five years, after which the rate adjusts to the index at one-year intervals.
ARM Rate Caps
ARM mortgages come with built-in rate caps to ensure that borrowers aren't overwhelmed by drastic increases in their monthly payments. Taken together, the various types of caps on a single ARM make up its cap structure.
Initial Cap: the maximum limit on the first rate adjustment at the end of the fixed-rate period. If the initial cap is 2% on an initial rate of 4%, for example, the highest your rate could go in the first period would be 6%.
Periodic Cap: upper limit on each rate adjustment after the first one. Sometimes equal to the initial cap, the periodic cap keeps the interest rate from climbing too high from the second adjustment onwards.
Lifetime Cap: total limit on how much the mortgage rate can exceed the initial rate at any point. With a lifetime cap of 5% and an initial rate of 4%, you would be guaranteed an upper limit of 9% regardless of adjustments.
Calculating Adjustable Rate Mortgage Payments
When you calculate monthly payments for a potential adjustable rate mortgage, keep in mind that the most popular types of ARMs include an initial period of fixed rate payments. For instance, this means that calculating the first five years of payments on a 5/1 ARM is no different from calculating payments on a fixed rate mortgage. To illustrate how you calculate the later variable payments, we need to start with a number of assumptions.
Example of a 5/1 ARM Mortgage
|Index Rate||1-Year Treasury CMT|
|Term Length||30 years|
Assume that in 2010, you took out a 5/1 ARM mortgage for a total loan of $240,000. The ARM rate was tied to the 1-Year Treasury Constant Maturity Rate (CMT) from 2010 to 2017, and you qualified for a 3% margin. Here's what your interest and principal costs would have looked like based on the data we found for the historical CMT rate.
5/1 ARM Monthly Principal and Interest
|Year||ARM Rate||Monthly Principal and Interest Payment||Remaining Balance|
As expected, we can calculate the first five years of payments on our hypothetical ARM the same way we do for payments on a fixed rate mortgage of 3.30%. However, the sixth year of our example sees a rate change that requires new calculation. We can figure out the new payment by using the same equation for a fixed rate mortgage —except that the balance and term length have changed due to the payments already made. For 2015, you would need to calculate the monthly payments on a 25-year mortgage at 3.18% with a total loan amount of $208,814.
Of course, this excludes the taxes and homeowner's insurance premiums you'll need to pay each month as well. Because the CMT rate declined in 2015, a borrower would be fortunate enough to come out of the five-year fixed period just in time to get a small discount on the monthly payment. In addition, the CMT rate has gone up since 2015, which promises a continuous increase in payments with each annual adjustment.
Pros and Cons of Adjustable Rate Mortgages
Fixed rate mortgages make the most sense for long-term borrowers who plan to pay off their debt completely, while adjustable rate mortgages help reduce monthly costs for people who plan to refinance or sell their home in a few years. Most ARMs allow an initial period of fixed rate payments at a lower average cost than equivalent fixed rate mortgages. For example, the 5/1 ARM gives borrowers a rate lock lasting five years before adjustment begins. This can be a useful way to secure a lower payment as you wait to sell your property or refinance your mortgage.
Adjustable Rate Mortgages
|Good for…||Bad for…|
However, there's no guarantee that you'll be ready to refinance or sell at a profit before the fixed rate period ends on your adjustable rate mortgage. If property values decline or your financial outlook takes a sudden hit, you may not be able to get out of the ARM before its interest rate climbs. Given these risks, many people opt for fixed rate mortgages even if they have plans to move in a few years. Monthly payments on a fixed rate mortgage stay the same throughout the entire repayment schedule. Many homeowners prefer paying slightly more in interest for the security and predictability of a fixed rate mortgage.