What is an Adjustable Rate Mortgage

What is an Adjustable Rate Mortgage

An adjustable-rate mortgage, or ARM, is a mortgage loan whose interest rate changes periodically based on a financial index; this means that your monthly mortgage payments can rise or fall over the life of the loan, depending on the movement of the index. Adjustable mortgage rates can be an excellent option for some borrowers, as they offer a lower initial interest rate than fixed-rate mortgages. However, they also carry some risks that borrowers must understand before signing up for an ARM.

Here's everything you need to know about adjustable mortgage rates:

How adjustable mortgage rates work

Adjustable mortgage rates are based on a financial index, such as the London Interbank Offered Rate (LIBOR), the Cost of Funds Index (COFI), or the Constant Maturity Treasury (CMT) rate. When you take out an ARM, your interest rate is typically fixed for a certain time, such as three, five, seven, or ten years. After the initial fixed-rate period, the interest rate will adjust periodically, typically once a year. The interest rate is calculated as the index rate plus a margin, a percentage added to the index rate.

For example, let's say you take out a five-year ARM with a starting interest rate of 3%. The index rate is based on the CMT rate, which is currently 1%. The margin on your loan is 2%. This means that your starting interest rate is 3% (1% + 2%). After the five-year fixed-rate period ends, the interest rate will adjust annually based on the CMT rate and the 2% margin.

Pros of adjustable mortgage rates

Lower initial interest rate: Adjustable mortgage rates often start out lower than fixed-rate mortgages. This can make them a good option for borrowers who only plan to stay in their homes for a few years or who expect their income to increase in the future.

Flexibility: Some adjustable mortgage rates come with features that allow you to make extra payments, change your payment due date, or convert to a fixed-rate mortgage at a later time. These options can provide flexibility and convenience for borrowers.

Cons of adjustable mortgage rates

Uncertainty: Adjustable mortgage rates are subject to change, which means your monthly mortgage payment can go up or down over the life of the loan. This can make it difficult to budget and plan for the future, especially if you're on a fixed income.

Risk: If interest rates rise significantly, your monthly mortgage payment could become unaffordable. This is especially true if you took out an ARM with a very low initial interest rate. You could end up owing more on your mortgage than your home is worth, which is known as being underwater.

Complexity: Adjustable mortgage rates can be more complex than fixed-rate mortgages, involving multiple variables and calculations. This can make it harder to understand exactly how your mortgage payment is calculated and what factors can cause it to change.

Conclusion

Adjustable mortgage rates can be a good option for some borrowers, especially those who plan to stay in their home for only a few years or expect their income to increase. However, they also carry some risks that borrowers must understand before signing up for an ARM. If you're considering an adjustable mortgage rate, talk to a lender or mortgage broker who can help you understand the pros and cons of this type of loan and whether it's right for your specific financial situation.

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