Adjustable-rate mortgage

An Adjustable-Rate Mortgage (ARM) is a type of home loan where the interest rate can change periodically, typically in relation to an index that reflects market conditions. This means your monthly mortgage payments can increase or decrease over time. ARMs are popular for those who may not plan to stay in their home long term or expect interest rates to drop in the future.

Key Features of an ARM:

1. Initial Fixed Period: ARMs usually start with a lower interest rate for a specified period (e.g., 3, 5, 7, or 10 years), during which the rate remains fixed. This period is known as the introductory or fixed-rate period.
2. Adjustable Period: After the fixed period ends, the interest rate adjusts periodically, typically once a year. The rate changes based on the current market interest rate index, such as the LIBOR (London Interbank Offered Rate) or the Treasury Index.
3. Rate Caps: ARMs usually have limits on how much the interest rate can increase at each adjustment period (yearly cap) and over the life of the loan (lifetime cap).
4. Hybrid ARMs: These are the most common ARMs and are often referred to with numbers like 5/1, 7/1, or 10/1 ARM. For example, a 5/1 ARM has a fixed interest rate for the first 5 years, and then the rate adjusts every 1 year after that.

How an ARM Works:

• Initial Period: During the fixed-rate period, you enjoy a lower interest rate compared to most fixed-rate mortgages, which means lower initial monthly payments.
• Adjustment Period: After the fixed-rate period ends, the interest rate adjusts based on the chosen index, plus a margin set by the lender. The adjusted rate will influence your new monthly payments.
• Caps: To protect borrowers, ARMs often include limits on how much the interest rate can increase or decrease at each adjustment. For example, a cap might limit an annual adjustment to a 2% increase and a lifetime increase to 5%.

Common ARM Structures:

1. 5/1 ARM: The interest rate is fixed for the first 5 years, then adjusts every year after that.
2. 7/1 ARM: The interest rate is fixed for the first 7 years, then adjusts annually.
3. 10/1 ARM: The interest rate is fixed for the first 10 years, then adjusts annually.

Pros of an ARM:

• Lower Initial Rates: ARMs typically offer lower initial interest rates compared to fixed-rate mortgages, which can result in lower initial monthly payments.
• Potential Savings: If interest rates fall during the adjustable period, your monthly payments could decrease.
• Good for Short-Term Ownership: If you plan to sell or refinance before the initial fixed-rate period ends, an ARM can provide significant savings during the early years.

Cons of an ARM:

• Rate Increases: Once the initial fixed-rate period ends, the rate can increase significantly, leading to higher monthly payments.
• Unpredictable Payments: Unlike a fixed-rate mortgage, your payments can change, making it harder to budget for the long term.
• Risk: If interest rates rise sharply, your monthly payments may become unaffordable.

Who Might Consider an ARM?

• Short-Term Homeowners: If you know you'll sell or refinance within a few years (before the adjustable period starts), the lower initial rate can save you money.
• Buyers Expecting Lower Rates: If you believe interest rates will drop, you could benefit from future adjustments.
• Those Expecting Income Growth: If your financial situation is likely to improve in the coming years, you may be more comfortable taking on the risk of potential rate increases later.

Caps on ARMs:

To limit the potential risk, ARMs include caps on how much your interest rate can adjust:

• Initial Adjustment Cap: Limits how much the rate can increase the first time it adjusts after the fixed period (e.g., no more than 2% increase).
• Subsequent Adjustment Cap: Limits how much the rate can increase at each subsequent adjustment (e.g., a 2% cap per year).
• Lifetime Cap: Limits how much the rate can increase over the life of the loan (e.g., a 5% total increase from the initial rate).