Adjustable Rate Mortgage (ARM)

Are you trying to figure out the difference between adjustable rate mortgages and fixed rate mortgages? Sammamish Mortgage provides a rundown of the pros and cons of ARMs vs fixed rate home loans.

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What is an Adjustable Rate Mortgage?

An adjustable rate mortgage or ARM is a loan with a variable interest rate that can change periodically over the course of the loan term. Adjustable-rate mortgages generally have an initial, or “introductory” fixed rate period followed by an adjustable rate period. The fixed rate period can range from as short as 1 month to as long as 10 years.

The most common adjustable rate mortgages are 3/1, 5/1, 7/1 and 10/1 ARMs. The initial 3, 5, 7 or 10 indicate the number of years the initial interest rate is fixed while the second number indicates the loan will adjust annually after the fixed rate period is over. These ARM programs are often referred to as Hybrid ARMs due to the initial fixed rate period.

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TermConforming 30 year fixed

Rate5.875%

APR6.078%

98004 | $800,000 | Credit Score 800+ | 25 Down

TermConforming 15 year fixed

Rate4.875%

APR5.269%

98004 | $800,000 | Credit Score 800+ | 25 Down

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How Does an Adjustable Rate Mortgage Work?

Below is a sample scenario of a 7/1 ARM

Initial rate: 3.75% – Fixed for the first 7 years of the loan
Index: 2.00 (can change) Most ARM’s use the 1 Year LIBOR Index
Margin: 2.25 (fixed and never changes)
Rate Caps: 5/2/5

Generally, an adjustable-rate mortgage will offer an initial rate for a certain period of time, whether it’s the first year, three years, five years, or longer. After that initial period ends, the ARM will adjust to its fully-indexed rate, which is the margin plus index.

You can look up your current index rate quickly with a web search. The margin will be specified in your Loan Estimate or Closing Disclosure (Formerly the GFE and TIL).

Based on the sample scenario, your fully-indexed rate would be 4.25%. While the sample uses the most common margin, index and rate caps it is important for a consumer to know the details of their adjustable rate mortgage.

Margins can vary from lender to lender as can the caps and index.

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Types of Adjustable-Rate Mortgages

There are many different types of adjustable rate mortgages, with the initial fixed rate period ranging from one-month to 10 years. Obviously this represents quite a range of risk, so be careful when comparing different loan products. Below are the most common ARM’s currently being available.

1-month ARM

First adjustment after one month, then adjusts monthly

6-month ARM

First adjustment after six months, then adjusts every six months

1-year ARM

First adjustment after one year, then adjusts annually

3/1 ARM

First adjustment after three years, then adjusts annually

5/1 ARM

First adjustment after five years, then adjusts annually

7/1 ARM

First adjustment after seven years, then adjusts annually

10/1 ARM

First adjustment after 10 years, then adjusts annually

Adjustable-Rate Mortgage Interest Rate Caps

An adjustable-rate mortgage will have rate caps which limit the amount your rate can go up or down once the adjustable rate period of the loan is triggered.

Typically caps for conventional loans are 2/2/6 or 5/2/5. Generally the shorter initial fixed rate loans use a 2/2/6 and the longer initial fixed rate loans use a 5/2/5. Keep in mind the interest rate can increase or decrease. If short term rates are low, your adjustable rate mortgage could possibly drop!

Initial

How much the rate can increase or decrease after the initial fixed rate period. In the sample scenario, it would allow for a maximum adjustment of 5% higher than the start rate after 7 years if the index and margin at that time warrant such an increase.

Periodic

The periodic rate cap in the sample of 2%, is the maximum allowable increase or decrease in rate each year after the first adjustment. In the sample this would be in year 8.

Lifetime

The amount the rate can change during the life of loan. In the sample the rate could never exceed 8.75% regardless of how high the index increased at any time during the 30 year loan term.

Why Choose an Adjustable-Rate Mortgage?

Ideally a borrower will choose an adjustable-rate mortgage when their intent is to sell the property prior to the first rate adjustment. Some homeowners get into adjustable-rate mortgages with the assumption that they can refinance the loan when the fixed period ends.

While this is often true, there is a risk that rates in the future may be higher. Qualification can also become an issue due to an unforeseen financial hardship or decrease in home values. It is important you understand the risks and rewards of an adjustable-rate mortgage prior to making your decision.

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FAQs

How do ARMs and fixed-rate mortgages differ?

A fixed-rate mortgage has a rate that doesn’t change for the life of the loan. An ARM starts with a fixed rate, then shifts to a variable rate that can go up or down.

What do the numbers in an ARM mean?

The first number indicates the length of the fixed-rate period (e.g., 5 years in a 5/1 ARM), and the second shows how often the rate adjusts afterward (e.g., every 1 year).

What happens when the fixed-rate period ends?

The interest rate adjusts periodically based on the loan’s index and margin, which can cause your monthly payment to increase or decrease.

What is an index and margin in an ARM?

The index is a benchmark interest rate, and the margin is a fixed percentage added to the index to determine your new rate.

Can I refinance an ARM?

Yes, many borrowers refinance into a fixed-rate mortgage before the adjustable period begins to avoid potential rate hikes.

What types of ARMs are available?

Common types include 5/1, 7/1, and 10/1 ARMs.

Who should consider an ARM?

ARMs may be ideal for buyers who plan to sell or refinance before the adjustable period starts, or who expect interest rates to go down.

What are the risks of an ARM?

The biggest risk is rising interest rates, which can significantly increase your monthly payments after the fixed period ends.

How do I know when my rate will change?

Your lender will notify you in advance. You can also sign up for alerts or check your loan documents for adjustment schedules.

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If you’re either looking or thinking about buying a home in WA, ID, CO, OR, or CA, reach out to Sammamish Mortgage today. No matter what stage of the process you’re in, we can provide valuable information which can help you. Contact Us today to learn more, or View Rates to get a sense of what current mortgage rates look like. You can also get a Rate Quote personalized to your situation, or Apply Now to jump start the application procedure.

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Adjustable Rate Mortgage (ARM)

Our Reputation Speaks For Itself

What is an Adjustable Rate Mortgage?

Find the Best Mortgage Deals for You

How Does an Adjustable Rate Mortgage Work?

Types of Adjustable-Rate Mortgages