2023 ARM Guide

About Adjustable-Rate Mortgages

Too often do borrowers make the mistake that a fixed-rate mortgage is the only type of mortgage available. But contrary to popular belief, there are many different ways that a mortgage can be structured.

While adjustable-rate mortgages (ARMs) have received a bad reputation in the past for being associated with subprime lending practices, they can actually provide a ton of upside if used correctly.

Much like other home mortgage loans, adjustable-rate mortgages have their own share of advantages and drawbacks. However, it's important you understand the features of an adjustable-rate mortgage before you shrug it off as a viable financing solution. 

If you are thinking about buying a new home or refinancing an existing mortgage, here are some considerations you should note when comparing what home mortgage best meets your housing needs.

How Do Adjustable-Rate Mortgages (ARMs) Work? 

Adjustable-rate mortgages are like other mortgage loans in that they are often paid over several years. Much like other loan products, the shorter your loan term generally the higher your monthly payment.

But unlike a fixed-rate mortgage, where your interest rate doesn’t change over the life of your loan, an adjustable-rate mortgage’s interest rate can fluctuate.1 For this reason, adjustable-rate mortgages are also often referred to by industry professionals as variable-rate mortgages. 

Calculating the Variable Rate on an Adjustable-Rate Mortgage

Generally, adjustable-rate mortgages have an introductory period where your interest rate is set at a fixed-rate for a specific period of time. Some lenders like to call this a teaser rate because it can often be lower than that of even a typical fixed-rate mortgage.

The initial fixed-rate period will be dependent on how your ARM is structured, but can often be 2, 5, or even 7 years. At the end of the introductory period, your rate will then become variable and is subject to adjustment often at set intervals. 

For example, in the case of a 5/1 ARM, the “5” represents your initial fixed -rate period of 5 years. The “1” represents how often the rate can adjust after the first interest rate adjustment, which in this case would be every year for the life of your loan. 

When your interest rate converts to a variable rate, it is calculated based on a specific benchmark index plus a set amount above that rate often expressed as a percent, referred to as the margin.1

While there are a few benchmark indices that your lender could use, one of the most common is the Secured Overnight Financing Rate (SOFR) which is a measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities.2 

As market conditions change, your interest rate can go either up or down and with it your subsequent monthly mortgage payment. 

Adjustable-Rate Mortgage Rate Caps 

Some adjustable-rate mortgages have set limits on how high or lower your interest rate can go. These are often referred to as interest rate caps. 

There are few different types of caps that your rate might be subject to, although this might not be indicative of all loans. The first is an initial adjustment cap which states that the first time your interest rate adjusts, it cannot exceed a certain tolerance, often expressed as a percentage.3 

Another type of interest rate cap is something called a subsequent adjustment cap. This refers to the periods that succeed the first adjustment following the initial fix-rate period.3 

Lastly, adjustable-rate mortgages usually have a lifetime adjustment cap that states your interest rate cannot increase or decrease beyond a certain amount over the entire life of your loan.3 

It's important to note that different lenders can have different interest rate caps, so if you are thinking about using an adjustable-rate mortgage, it's important to compare different rate caps between lenders.

Pros and Cons to Using an Adjust-Rate Mortgage

Depending on your financial situation, an adjustable-rate mortgage can offer many benefits over your standard fixed-rate mortgage. However, if used incorrectly there can also be some potential drawbacks. 

One scenario where an adjustable-rate mortgage might be advantageous is if you are buying or refinancing a home but don’t plan on living in the property for an extended amount of time. 

If your goal is to move or sell within a brief time horizon, you might benefit from the lower teaser rate offered through the introductory period through a lower payment and paying less in interest. For this reason, ARMs can be an extremely flexible financing option.

Another benefit to using an adjustable-rate mortgage is that your rate could potentially go down depending on how the market is trending. This could mean your payment could decrease and free up money for your monthly budget.

Conversely, there is always the risk that your interest rate could go up over the life of your loan and with it your monthly payment. If you don’t plan accordingly, you could end up in a worse financing spot. 

If you have an adjustable-rate mortgage and you planned to sell your property before your first interest rate adjustment, but for some reason can’t (or it's delayed), you could end up paying a lot more or worse, be at greater risk of default.

Lastly, some ARMs have prepayment penalties, meaning that if you pay off your loan early then you will have to pay an additional fee. Make sure to read the fine print before you agree to a mortgage that has a prepayment penalty, so you understand all the terms and conditions.

Comparing Adjustable-Rate Mortgage Options

A lot of borrowers stray away from considering adjustable-rate mortgages because of their inherent complexity. Nevertheless, if you are the right kind of borrower, an ARM may offer you the opportunity to save money or lower your monthly payment.

However, because adjustable-rate mortgages can be structured in a variety of ways, be it the initial fixed-rate period, the benchmark index being used, or even a prepayment penalty provision, it's important to compare your mortgage options across multiple lenders.

Analyze all your adjustable-rate mortgage options with ReviewMyMortgage.com’s Self-Diagnosis tool which allows you to compare multiple loan options all at once.

Even if you are on the fence deciding whether an adjustable-rate mortgage is right for you, you can compare pricing between both fixed-rate and adjustable-rate solutions, so you know you are getting the best deal possible.

If you still have doubts or have a unique scenario, contact one of ReviewMyMortgage.com’s preferred lenders that can discuss your individual borrowing needs.

Sources

1 Consumer Financial Protection Bureau. (2020a, September 4). What is the difference between a fixed-rate and adjustable-rate mortgage (ARM) loan? Retrieved March 16, 2022, from https://www.consumerfinance.gov/ask-cfpb/what-is-the-difference-between-a-fixed-rate-and-adjustable-rate-mortgage-arm-loan-en-100/

2 Federal Reserve Bank of New York. (n.d.). Secured Overnight Financing Rate Data - FEDERAL RESERVE BANK of NEW YORK. Retrieved March 16, 2022, from https://www.newyorkfed.org/markets/reference-rates/sofr

3 Consumer Financial Protection Bureau. (2020, September 4). With an adjustable-rate mortgage (ARM), what are rate caps and how do they work? Retrieved March 16, 2022, from https://www.consumerfinance.gov/ask-cfpb/with-an-adjustable-rate-mortgage-arm-what-are-rate-caps-and-how-do-they-work-en-1951/