Adjustable Rate Mortgage (ARM) Loans

Download the Consumer Handbook on ARMs

Adjustable Rate Mortgages (ARMs) are loans with interest rates that change. You need to compare the features of ARMs to find the one that best fits your needs. This consumer handbook can help make sense of it all.
Adjustable Rate Mortgage (ARM)
An ARM gives you a fixed rate term, usually three, five, seven or ten years, with adjustable rates thereafter.
Today homebuyers are in a unique position to combine the benefits of a fixed rate mortgage with the savings opportunities of an adjustable rate mortgage. With a ARM's (also called a fixed-period ARM or hybrid ARM) you get the best of both worlds.

An ARM gives you a fixed rate term, usually three, five, seven or ten years, with adjustable rates thereafter. These loans are typically expressed as a 3/1, 5/1, 7/1 or 10/1 ARM. The first number represents the number of years the rates are fixed. The second number indicates the adjustment interval (how often the interest rate will change). For a 7/1 loan, the fixed period is seven years with annual interest rate adjustments thereafter.

The advantage of an ARM is that it gives you a lower fixed rate mortgage than you'll typically receive with a 30 year mortgage. This is often an attractive loan choice for borrowers who expect to be selling their home within the first 10 years. You'll get the advantage of a lower fixed rate while you're living in the home. And if your plans remain steady, the adjustable rate wouldn't be due until after you plan to move. ARM's are also an attractive loan choice for borrowers who want a fixed rate loan, but feel they will not be in the home for 30 years and want to take advantage of a lower rate that an ARM can offer.

Most ARM programs have a "cap" that protects you from your monthly payment going up too much at once. There may be a cap on how much your interest rate can go up in one period -- say, no more than two percent per year, even if the underlying index goes up by more than two percent. You may have a "payment cap," that instead of capping the interest rate directly caps the amount your monthly payment can go up in one period. In addition, almost all ARM programs have a "lifetime cap" -- your interest rate can never exceed that cap amount, no matter what. The most used cap structure is known as 5-2-5. This means that the first year adjustment cap is 5% over the start rate, each successive annual adjustment can be no more than 2% over the previously adjusted rate, and finally the lifetime adjustment cap is no more than 5% over the initial start rate of the loan. Remember, rates can adjust up or down but never lower than the margin on the ARM. How rates adjust is a simple mathematical formula.

For example:

Assume a 5/1 ARM with 5-2-5 caps tied to the LIBOR index with a margin of 2.25%.

This means that at the end of year 5 of the loan (the fixed period), the rate will adjust and it will adjust every year after that until year 30.

The caps dictate the first year adjustment in year 6 cannot be more than 5% above the initial rate on the loan and also the lifetime adjustments can never exceed 5% above the initial rate. If the first adjustment year does not adjust more than 5%, then the annual adjustment can never be more than 2% in any successive year and never more than 5% over the life of the loan.

The adjustment is calculated by adding the margin (2.25% in our example) to the LIBOR index, let's say 3.89% and rounding it up to the nearest .125%. 2.25+3.89=6.14% rounded up to 6.25%. There is no element of guesswork in this calculation. It is a simple mathematical calculation with no hidden secrets.

ARMs often have their lowest, most attractive rates at the beginning of the loan, and can guarantee that rate for anywhere from a month to ten years. You may hear people talking about or you may read about loans that are called "3/1 ARMs" or "5/1 ARMs" or the like. That means that the introductory rate is set for three or five years, and then adjusts according to an index every year thereafter for the life of the loan. Loans like this are often best for people who anticipate moving -- and therefore selling the house to be mortgaged -- within three or five years, depending on how long the lower rate will be in effect.