What is an adjustable-rate mortgage?
Updated August 2, 2021
An adjustable-rate mortgage, or ARM, is one in which the interest rate on the outstanding balance varies or “adjusts” over the lifetime of the loan.
Under an adjustable-rate mortgage, which is also known as a variable-rate mortgage or a floating mortgage, the initial interest rate is fixed for a period of time, then resets or adjusts periodically based on an index, plus a set margin.
While adjustable-rate mortgages keep initial rates lower than those on conventional mortgages, they can be risky because the borrower may not be able to cover the higher costs when and if they adjust upward. However, the initial lower rates allow borrowers to buy a more expensive home while making lower payments during the first years of the loan.
The initial interest rates on adjustable-rate mortgages typically are lower than those on fixed-rate
versions, whose interest rates remain the same throughout the duration of the loan and are tied to the 10-year Treasury bond. While the index rates on an adjustable-rate mortgage can change, the margin, which is set by the lender to cover expenses and make a profit, does not. The margin typically is 1% to 3%.
The interest rate will go down when the index decreases, and it will go up when the index does.
Typically, one of three indexes is used at the close of the fixed-rate period: the maturity yield on one-year Treasury bills, which are short-term debt obligations issued by the U.S. Treasury; the 11th District cost of funds index, which is a monthly weighted average of interest rates paid on checking and savings accounts at financial institutions in Arizona, California and Nevada; or the London interbank offered rate (Libor), which is the interest-rate average calculated from estimates by London’s leading banks.
Libor as an index was phased out after 2021; the secured overnight financing rate, or SOFR, which is the secured interbank overnight interest rate and reference rate, is its replacement.
Adjustable-rate mortgages offer different fixed-rate periods, and each can be evaluated with a mortgage calculator to determine which is the best deal.
The terms of the adjustable-rate mortgage are expressed with two figures: The number of years the fixed rate is in effect followed by the period of time of each adjustment.
The length of the fixed-rate period varies. So does the frequency of the adjustment period: It can be several years, quarterly, annually or even monthly; generally, the shorter the adjustment period, the lower the initial interest rate.
For example, a 5/1 adjustable-rate mortgage has a fixed rate for five years, then adjusts every year thereafter, while a 5/5 adjusts every five years after a five-year period of the same rate.
Adjustable-rate mortgages also can include a variety of caps on the interest rates. Some limit the amount the rate can increase each adjustment period; others put caps on the total monthly payments. Called negative amortization loans, these adjustable-rate mortgages ensure low interest rates, but the payments may not be enough to cover all the interest due, so unpaid interest is added to the principal.
This may create a situation where the principal owed may be larger than the amount originally borrowed.
ARMs also include ceilings that limit the highest interest rate during the duration of the loan.
Although some adjustable-rate mortgages include provisions for converting to a fixed-rate mortgage, some charge prepayment penalties if the borrower refinances the loan or pays it off early.
Adjustable-rate mortgages are so complicated that several studies, including one in 1991 by the U.S. Government Accountability Office, showed significant interest rate errors that negatively impacted a large percentage of borrowers.
Who Should Consider Them
Adjustable-rate mortgages are not without risk and are not appropriate for every home buyer.
Those who plan on owning a home for a short period of time may find it advantageous to take out an adjustable-rate loan since the fixed-rate period for an adjustable-rate mortgage generally is only from one to seven years.
It also may be a good option for buyers who expect their incomes to increase dramatically, because it allows them to afford the potentially higher interest rates during the adjustment periods and/or purchase a more expensive property.
For buyers who plan on paying off the loan before the rate resets, an adjustable-rate mortgage may be a sensible solution.
Adjustable-rate mortgages, which became popular in the U.S. in 2004 when interest rates on conventional mortgages rose, date to 1980, when the Federal Home Loan Bank Board authorized savings and loans to offer them to home buyers.
They are the home loan of choice in several parts of the world, including the United Kingdom, Ireland and Canada.