What is an Adjustable Rate Mortgage?

Variable Rate Mortgage

An adjustable rate mortgage (ARM) is a mortgage loan with an interest rate that varies based on an economic index–which is typically the fed funds rate, the one-year Treasury bill, or the Libor rate. In adjustable rate mortgages, your monthly payment can increase and decrease periodically, unlike a fixed-rate mortgage where you’ll have a set interest rate for the life of the loan.

Adjustable rate mortgages can be helpful for homebuyers who plan to pay off the loan within a specific amount of time because the initial interest rate is typically lower than fixed rate mortgages.

How does an Adjustable Rate Mortgage work?

Adjustable rate mortgages follow rate indexes and margins. To set the initial rate, your lender will take the index rate and determine how many points they’ll add to it. After the initial period ends, your interest rate can then fluctuate, monthly, quarterly, annually, or every 3 to 5 years, depending on which loan you get.

While the index rate can change, the margin will always stay the same. For example, if the index is 2% and the margin is 2%, the interest rate will adjust to 4%. Then, if the index is 0.5, the interest rate will adjust to 2.5%.

Variable-rate mortgages are also expressed as two numbers, like 1/1, 3/1, 5/1, and 5/5. The first number indicates the initial fixed-rate period of the loan expressed in years, while the second number is how often it adjusts.

For example, a 3/1 ARM has a fixed rate for three years, followed by a variable rate for one year. Meanwhile, a 2/28 ARM will have a fixed rate for two years, followed by a variable rate for 28 years.

What is the difference between Adjustable and Fixed mortgage?

The biggest difference between an adjustable rate mortgage and a fixed mortgage is their interest rates. Interest rates for fixed rate mortgages remain the same for the life of the loan, while the interest rates for adjustable rate mortgages can increase or decrease.

Here’s a visual example for reference.

3/1 ARM	Fixed Rate Mortgage
Mortgage Amount $250,000	Mortgage Amount $250,000
Interest Rate: 2.9%	Interest Rate: 3.25%
Montly payment $1,714 (after 3 years this amount can increase or decrease, depending on the new interest rate.	Monthly payment $1,757

If you’re interested in an adjustable rate mortgage, you should talk with your lender to evaluate the pros and cons, and to let you know how much your mortgage payments may increase.

Risks of an Adjustable Rate Mortgage

Although you can get a lower interest rate than a fixed mortgage, in the beginning, it won’t always be that way. This is why the biggest disadvantage with ARMs is interest rate risk. When the loan resets, your interest rate and mortgage payment could rise. And if you can’t afford your new payment, you could lose your home. Other risks of ARMs include:

• Negative amortization
• Prepayment penalties
• A drop in housing prices

You really need to understand what you’re getting into with adjustable rate mortgages and your lender should lay out some worst-case scenarios so you aren’t shocked when your payment suddenly increases.

If you have questions about mortgages, contact us or stop by any of our People’s branches. We’ll happily answer any questions you may have and help guide you in the right direction. In the meantime, you can also visit our website and evaluate our current fixed mortgage rates.