Description

An adjustable rate mortgage (ARM) is a mortgage loan whose interest rate is adjusted periodically based on certain parameters (as described below). The 5-year and 7-year adjustable rate mortgages are the most common although other terms are often available (from 3 to 10 years).

Basic Elements of ARMs

  • Initial rate: The preliminary interest rate.
  • The adjustment period: The period in which the current rate will remain consistent.
  • The index rate: The future rate changes are based off a variety of indices such as the LIBOR.
  • The margin: The percentage which gets added to the index rate to determine the adjusted interest rate.
  • Interest rate cap: The percentage of change which can be added to or deducted from your current rate.
  • Ceiling: The highest interest rate permitted during the life of the loan.

Advantages

  • Interest rates and payments are typically lower than fixed-rate mortgages (FRMs)
  • Rate may decrease after the initial period
  • Typically allows borrowers to qualify for a larger loan
  • Great for homeowners who do not plan to live in the property longer than the initial term
  • Great for investors who plan to flip the property within a relatively short period
  • Free up money each month for living expenses or investments

Disadvantages

  • Rate may increase after the initial period
  • Can be difficult to understand
  • Borrowers must refinance before the initial period expires to maintain a guaranteed rate
  • Could cost more in the long run if the loan is kept past the initial fixed period

ARM Examples

10/1 ARM: Your interest rate is set for 10 years then adjusts for 20 years.

7/1 ARM: Your interest rate is set for 7 years then adjusts for 23 years.

5/1 ARM: Your interest rate is set for 5 years then adjusts for 25 years.

3/1 ARM: Your interest rate is set for 3 years then adjusts for 27 years.

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