What Is an Adjustable-Rate Mortgage (ARM)?
The term adjustable-rate mortgage (ARM) refers to a home loan with a variable interest rate. With an ARM, the initial interest rate is fixed for a period of time. After that, the interest rate applied on the outstanding balance resets periodically, at yearly or even monthly intervals.
ARMs are also called variable-rate mortgages or floating mortgages. The interest rate for ARMs is reset based on a benchmark or index, plus an additional spread called an ARM margin. The typical index that is used in ARMs has been the London Interbank Offered Rate (LIBOR).
- An adjustable-rate mortgage is a home loan with an interest rate that can fluctuate periodically based on the performance of a specific benchmark.
- ARMS are also called variable rate or floating mortgages.
- ARMs generally have caps that limit how much the interest rate and/or payments can rise per year or over the lifetime of the loan.
- An ARM can be a smart financial choice for homebuyers who are planning to keep the loan for a limited period of time and can afford any potential increases in their interest rate.
Understanding Adjustable-Rate Mortgages (ARMs)
Mortgages allow homeowners to finance the purchase of a home or other piece of property. When you get a mortgage, you’ll need to repay the borrowed sum over a set number of years as well as pay the lender something extra to compensate them for their troubles and the likelihood that inflation will erode the value of the balance by the time the funds are reimbursed.
In most cases, you can choose the type of mortgage loan that best suits your needs. A fixed-rate mortgage comes with a fixed interest rate for the entirety of the loan. As such, your payments remain the same. An ARM, where the rate fluctuates based on market conditions. This means that you benefit from falling rates and also run the risk if rates increase.
There are two different periods to an ARM. One is the fixed period and the other is the adjusted period.
Here’s how the two differ:
Fixed Period: The interest rate doesn’t change during this period. It can range anywhere between the first five, seven, or 10 years of the loan. This is commonly known as the intro or teaser rate.
Adjusted Period: This is the point at which the rate changes. Changes are made during this period based on the underlying benchmark, which fluctuates based on market conditions.
Another key characteristic of ARMs is whether they are conforming or nonconforming loans. Conforming loans are those that meet the standards of government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. They are packaged and sold off on the secondary market to investors. Nonconforming loans, on the other hand, aren’t up to the standards of these entities and aren’t sold as investments.
Rates are capped on ARMs. This means that there are limits on the highest possible rate a borrower must pay. Keep in mind, though, that your credit score plays an important role in determining how much you’ll pay. So, the better your score, the lower your rate.