Home Loans

How Does an Adjustable Rate Mortgage Work?

Oct 7, 2018, 1:50 PM | Sarah Woodbury
A street view of homes, some of which may have adjustable rate mortgages

If you're in the market for a home loan, you may have heard of the adjustable rate mortgage. It is less common than a fixed-rate mortgage, but depending on your circumstances, it might be just the right mortgage type for you, potentially even saving you money.

What Is an Adjustable Rate Mortgage?

An adjustable rate mortgage (ARM) is a mortgage with an interest rate that reflects the market, causing it to change over time rather than remaining constant like with a fixed-rate mortgage.

However, there is often a period of time at the beginning of an ARM during which it has a fixed rate. You'll sometimes hear ARMs with this feature called "hybrid ARMs" or "hybrid mortgages." After the fixed rate stage, the rate can change depending on the market index, margin, and loan terms.

It's important to note that not all ARM loans have this initial fixed period.

How Long Is the Rate Fixed for a Hybrid Adjustable Rate Mortgage?

The rate on an ARM can be fixed for different amounts of time, from just a month to fifteen years, depending on your loan. After that, the rate can fluctuate up or down and often has caps on the percentage it is allowed to change.

For example, you might see an initial rate and period of 3/1, which means that for three years, you keep your initial interest rate, but after that, annual adjustments can be made to the rate.

Factors That Influence the Rates

The basis for rate changes in an ARM is the fully indexed rate, or the sum of the market index and margin.

The market index is a rate percentage that is based on a market chosen by your lender. A common market used is the London Interbank Offered Rate (LIBOR), but there are others used as well, like the Prime Rate or Fannie Mae 30/60. The index reflects how the market is doing and affects your rates.

Basically, if your market takes a hit, your interest rate will likely increase, while more favorable changes could reflect on your rate as well. The index is added to the margin to determine your rate.

The margin is a fixed percentage point amount, set by your lender, added onto the index to define how much your rate will be when the initial period is over.

How Much Can the Rate Change?

The interest rate for an ARM often has caps for different aspects of the loan.

The following are the different types of caps that may be part of your ARM, using the above 3/1 scenario:

  • Initial Cap – In a hybrid, the percentage your interest rate can change just after the initial period, or three years.
  • Periodic Cap – The percentage your interest rate can change each period. In this example, the period is equal to a year.
  • Lifetime Cap – The percentage your interest rate can change overall. So, if the previous example is a 30-year-loan, this amount would tell you how much your interest rate is permitted to change during those 30 years.

For example, if you have a rate cap of 2/2/6, which is common for a 3/1 ARM, this means that the initial cap is 2%, the periodic cap is 2%, and the lifetime cap is 6%.

You may also have monthly payment caps on your mortgage, which limits how much you can spend per month.

However, keep in mind that if interest rates would make your payment higher than the cap, you'd pay what the cap is, but you would still owe the interest.

The interest you still owe gets added to your total loan balance, so instead your balance decreasing with each payment, you could actually see it increase. This situation is called negative amortization.

Other Options for an Adjustable Rate Mortgage

  • Interest-Only — For this type of ARM, you pay only interest on the loan for a certain amount of time. You'll still owe the principal, but it will be paid later. It is important to note that interest-only ARMs can be highly risky, and only make financial sense in a few very specific situations.

  • Payment-Option — For this type of ARM, you have a few different payment options offered to you each month. You only have to pay the smallest of the payments to hold onto the loan; however, this will increase the balance of your loan and can substantially increase your payment amount if the loan resets.

When to Consider an Adjustable Rate Mortgage

ARMs are a mortgage type that takes on risk that can sometimes be quite substantial. The majority of mortgage borrowers choose a fixed rate because of its stability, but an ARM may work better for you, depending on your situation.

Typically, situations in which you may benefit by using an ARM include:

  • If you plan to sell or refinance the home before the end of the initial period (specifically for a hybrid ARM)
  • If your expected career or income is enough to cover potential rate increases
  • If you want a lower interest rate so you can get approved for a larger loan
  • If you're confident that the market is more likely to change in your favor

In addition to the risks associated with an ARM loan, there are also a lot of benefits. To help you decide if an ARM is right for you, take a look at this article discussing the pros and cons of an ARM loan. Or call and speak with a mortgage loan officer today.

If You're Ready for a Mortgage

If you're looking to take out a home loan, it's important to get bids from multiple lenders before you decide on a specific loan. You'll find many varying terms and rates between lenders, so in order to get the best deal, you'll want to make sure to compare them.

You'll especially want to look at what will affect the rate in the future—including the rate caps, margin & index details, etc.—so you can make an informed decision and avoid and unwanted surprises in the future.

For More Information

At Elevate, we are committed to each of our clients' individual goals and circumstances. We make sure to hire members of our team who care about the future of you and your family, and we are ready to help you find the right home and mortgage for you.

Call us at 888-657-2848 with questions on where to start, further information about ARMs, or to begin the loan process today.

Sarah Woodbury