Adjustable Rate Mortgages (ARMs)
A Powerful Financial Tool – But is it Right for You?
We're dedicated to helping you understand how mortgages work and, more importantly, how they can work to your advantage. One potentially advantageous loan program, in a rising interest rate environment, is the sometimes-overlooked Adjustable Rate Mortgage. Commonly referred to as an ARM, this type of mortgage can offer superior flexibility and savings over fixed rate mortgages.
How does an adjustable mortgage loan work?
Adjustable home loans feature start rates lower than those of fixed rate loans. This is particularly applicable to jumbo adjustable mortgage rates, and typically enables you to begin with lower monthly payments and qualify for a larger loan. When the initial rates expire, as the name implies, the rates periodically adjust upward or downward in alignment with market conditions. Consequently, as rates rise and fall, your monthly payments will rise and fall accordingly. For your protection, safeguards limit how high your loan rates can climb.
Let's take a closer look at how it works:
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The start rate, also known as the initial interest rate, gives you a lower monthly payment for a set period of time. Common initial interest rate periods are 3, 5, 7, and 10 years.
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When the start rate period is over, the interest rate adjusts in 1-month, 6-month, or 1-year intervals based on the performance of an adjustable rate mortgage index, such as the Cost of Funds Index (COFI) or the London Interbank Offered Rate (LIBOR) adjustable rate mortgage index.
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The frequency of the rate adjustments is based on the adjustable rate mortgage index, and how much rates and payments increase during each adjustment depends upon the terms of your loan. A 1-month ARM - such as an option ARM mortgage loan - potentially adjusts every month, while a 1-year LIBOR ARM mortgage potentially adjusts once a year.
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When your rates adjust, the new rate is determined by adding a margin to your adjustable rate mortgage index.
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A margin is a predetermined amount that remains the same for the life of the loan.
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Limits or "caps" can restrict the maximum amount your rate can increase. Periodic caps limit the maximum amount your rate can increase in one adjustment. Life caps establish the maximum amount your rate can increase during the life of the loan.
Is an adjustable mortgage loan the right loan for you?
An adjustable home loan can be an excellent choice if any of these apply to you:
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You anticipate that your income will increase.
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You plan to sell or refinance your home in a few years.
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You want to maximize your cash flow.
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You are willing to accept the associated risk in order obtain a lower interest rate.
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You are comfortable with periodic interest rate changes in exchange for being able to afford more home now.
Example 1:
Now that you understand the basic principles and mechanics of an adjustable home loan, let's look at an example of the savings it can offer.
Loan Amount$500,000$500,000
Loan Program30 Year Fixed3/1 ARM*
Interest Rate/APR6.250% / 6.321%4.875% / 4.941%
Monthly Payment$3,079$2,646
*3 year initial fixed rate, adjusts annually thereafter.
Example 2:
Let's also look at it a different way. Say you want to spend a maximum of $2,500 per month on your mortgage. The example below shows the difference in how much home you would be able to afford with an ARM, as opposed to a fixed-rate loan.
Monthly Payment$2,500$2,500
Loan Program30 Year Fixed3/1 ARM*
Interest Rate/APR6.250% / 6.321%4.875% / 4.941%
Loan Amount$406,000$472,500
As you can see, an adjustable mortgage loan can save you a significant amount of money every month or enable you to purchase a substantially more valuable home. We recommend you use an adjustable rate mortgage payment calculator for additional comparisons. For more information about adjustable mortgage loans and for all your mortgage needs, please contact us today.
Click here for an adjustable rate mortgage definition and other mortgage term definitions.