Most ARMs have two periods. During the first period, your interest rate is fixed and won’t change. During the second period, your rate goes up and down regularly based on market changes.
Most ARMs have a 30-year loan term.
5 / 1 Adjustable rate mortgage (ARM)
Fixed period | Adjustable period |
|---|---|
| This “5” is the number of years your initial interest rate will stay fixed. | This “1” is the how often your rate will adjust after the fixed period ends. |
| Common fixed periods are 3, 5, 7, and 10 years. | The most common adjustment period is “1,” meaning you will get a new rate and new payment amount every year once the fixed period ends. Other, less common adjustment periods include “3” (once every 3 years) and “5” (once every 5 years). You will be notified in advance of the change. |
ARMs can have other structures.
Some ARMs may adjust more frequently, and there’s not a standard way that these types of loans are described. If you’re considering a nonstandard structure, make sure to carefully read the rules and ask questions about when and how your rate and payment can adjust.
Understand the fine print.
ARMs include specific rules that dictate how your mortgage works. These rules control how your rate is calculated and how much your rate and payment can adjust. Not all lenders follow the same rules, so ask questions to make sure you understand how these rules work.
ARMs marketed to people with lower credit scores tend to be riskier for the borrower.
If you have a credit score in the mid-600s or below, you might be offered ARMs that contain risky features like higher rates, rates that adjust more frequently, pre-payment penalties, and loan balances that can increase. Consult with multiple lenders and get a quote for an FHA loan as well. Then, you can compare all your options.
For an adjustable-rate mortgage, the index is a benchmark interest rate that reflects general market conditions and the margin is a number set by your lender when you apply for your loan. The index and margin are added together to become your interest rate when your initial rate expires.
With an adjustable-rate mortgage, the rate stays the same, generally for the first year or few years, and then it begins to adjust periodically. Once the rate begins to adjust, the changes to your interest rate are based on the market, not your personal financial situation.
To calculate your new interest rate when it’s time for it to adjust, lenders use two numbers: the index and the margin.
Index + Margin = Your Interest Rate
The index is a benchmark interest rate that reflects general market conditions. The index changes based on the market. Changes in the index, along with your loan’s margin, determine the changes to the interest rate for an adjustable-rate mortgage loan. The lender decides which index your loan will use when you apply for the loan, and this choice generally won’t change after closing.
The margin is the number of percentage points added to the index by the mortgage lender to set your interest rate on an adjustable-rate mortgage (ARM) after the initial rate period ends. The margin is set in your loan agreement and won’t change after closing. The margin amount depends on the particular lender and loan.
The fully indexed rate is equal to the margin plus the index.
Is an ARM right for you?
ARMs come with the risk of higher payments in the future that you might not be able to predict. But in some situations, an ARM might make sense for you. If you are considering an ARM, be sure to understand the tradeoffs.
TIP
Don’t count on being able to refinance before your interest rate and monthly payments increase. You might not qualify for refinancing if the value of your home goes down or if something unexpected damages your financial situation, like a job loss or medical costs.
COMPARE | FIXED-RATE MORTGAGE | ADJUSTABLE-RATE MORTGAGE |
Consider this option if | You prefer predictable payments, or You plan to keep your home for a long period of time | You are confident you can afford increases in your monthly payment—even to the maximum amount, or You plan to sell your home within a short period of time |
Interest rate | Set when you take out the loan Stays the same for the entire loan term | Based on an index that changes May start out lower than a fixed rate mortgage but you bear the risk of increases throughout your loan |
Monthly payment | Principal and interest payment stays the same over the life of your loan You know the total you will pay in principal and interest over the life of the loan | Initial principal and interest payment amount remains in effect for a limited period You can’t know in advance how much total interest you will pay because your interest rate changes If you can’t afford the increased payments, you may lose your home to foreclosure |
Interest rate = index + margin
The interest rate on an ARM has two parts: the index and the margin.
INDEX
An index is a measure of interest rates generally that reflects trends in the overall economy. Different lenders use different indexes for their ARM programs.
Common indexes include the U.S. prime rate and the Constant Maturity Treasury (CMT) rate. Talk with your lender to find out more about the index they use, which is also shown on your Loan Estimate.
MARGIN
The margin is an extra percentage that the lender adds to the index.
You can shop around to different lenders to find the lowest combination of the index plus the margin.
Changes to initial rate and payment
The initial interest rate and initial principal and interest payment amount on an ARM remain in effect for a limited period.
So, when you see ARMs advertised as 5/1 or 5/6m ARMs:
- The first number tells you the length of time your initial interest rate lasts.
- The second number tells you how often the rate changes after that.
For example, during the first five years in a 5/6m ARM your rate stays the same. After that, the rate may adjust every six months (the 6m in the 5/6m example) until the loan is paid off. This period between rate changes is called the adjustment period. Adjustment periods can vary. Some last a month, a year, or like this example, six months.
For some ARMs, the initial rate and payment can be very different from the rates and payments later in the loan term. Even if the market for interest rates is stable, your rates and payments could change a lot.
Review your lender’s ARM program disclosure
Your lender gives you an ARM program disclosure when they give you an application. This is the lender’s opportunity to tell you about their different ARM loans and how the loans work. The index and margin can differ from one lender to another, so it is helpful to compare offers from different lenders.
Generally, the index your lender uses won’t change after you get your loan, but your loan contract may allow the lender to switch to a different index in some situations.
- How are the interest rate and payment determined?
- Does this loan have interest-rate caps (that is, limits on interest rate changes)?
- How often do the interest rate and payment adjust?
- What index is used and where is it published?
- Is the initial interest rate lower than the fully indexed rate? (see “Teaser rates,” on page 12)
- What type of information is provided in notices of adjustment and when do I receive them?
Ask about other options offered by your lender
Conversion option
Your loan agreement may include a clause that lets you convert the ARM to a fixed-rate mortgage in the future.
When you convert, the new rate is generally set using a formula given in your loan documents. That fixed rate may be higher or lower than interest rates available to you in the market at that time. Also your lender may charge you a conversion fee. Ask your lender whether the loan you are being offered has a conversion feature and how it works.
Special features
You can shop around to understand what special ARM features may be available from different lenders.
Not all programs are the same. Talk with your lender to find out if there’s anything special about their ARM programs that you may find valuable.
Check your ARM for features that could pose risks
Some types of ARMs have features that can reduce your payments in the short term but may include fees or the risk of higher payments later. Review your loan terms and make sure that you understand the fees and how your rate and payment may change. Lower payments at the beginning could mean higher fees or much higher payments later.
Paying points to reduce your initial interest rate
Lenders can offer you a lower rate in exchange for paying loan fees at closing, or points.
With an ARM, paying points often reduces your interest rate only until the end of the initial period—the reduction most likely does not apply over the life of your loan.
If you are using an ARM to refinance a loan, points are often rolled into your new loan amount. You might not realize you are paying points unless you look carefully. Points are disclosed on the top of Page 2 of your Loan Estimate.
Lenders may give you the option to pay points, but you never have to take that option. To figure out if you have a good deal, compare your cost in points with the amount that you will save with a lower interest rate.
Interest-only ARMs
With an interest-only ARM payment plan, you pay only the interest for a specified number of years. During this interest-only period, you have smaller monthly payments, but you are not paying anything toward your mortgage loan balance.
When the interest-only period ends, your monthly payment increases—even if interest rates stay the same—because you must start paying back the principal plus the interest each month. Your monthly payments can increase a lot. The longer the interest-only period, the more your monthly payments increase after the interest-only period ends.
Payment option ARMs
Payment option ARMs were common before 2008 when the housing crisis began, and some lenders might still offer them.
- A payment option ARM means the borrower can choose from different payment options, such as:
- A traditional principal and interest payment
- An interest-only payment (see above)
- A minimum payment, which could result in negative amortization
Negation – Negative amortization happens when you are not paying enough to cover all of the interest due. Your loan balance goes up instead of down.