With a fixed-rate mortgage, the interest rate, your monthly principal and interest payment stay the same throughout the life of your loan. With an adjustable-rate mortgage (ARM), the interest rate changes periodically, and your payments may go up or down.
ARMs have two distinct periods:
- Initial period: Also known as the fixed-rate period. During this time, the interest rate on your loan doesn’t change. The initial period can range from six months to 10 years. The most common ARM terms will have an initial period of 3, 5, or 10 years.
- Adjustment period: All ARMs have adjustment periods that determine when and how often the interest rate can change. Your adjusted rate will be based on your individual loan terms and the current market.
There are different types of ARMs.
- The name of the ARM will indicate the duration of the initial period
- How often in a year your rate can adjust during the adjustment period
For example, let’s look at a 5/1 ARM. The initial period is five years (the 5), during which the interest rate doesn’t change. After that time, you can expect your ARM to adjust once a year (the 1).
Most ARMs also typically offer a rate cap structure, which is meant to limit how much your rate can increase or decrease. There are three different caps:
- Initial cap: Limits how much your rate can increase when your rate first adjusts
- Periodic cap: Limits how much your rate can increase from one adjustment period to the next
- Lifetime cap: Limits how much your rate can increase or decrease over the life of the loan
Yes. The terms ARM (adjustable-rate mortgage) and variable-rate mortgage both refer to the type of loan where the interest rate changes periodically.
An index is a benchmark used to determine a baseline interest rate. Every ARM loan is tied to an index. The index for your ARM is listed in your original loan documents. Margin is a fixed percentage that is added to the index rate to calculate the new interest rate. Index + Margin = Interest Rate.
When your interest rate adjusts, we also calculate the amount of your monthly payment that will be applied to the principal – which is the remaining balance on your loan. To do this, we determine the principal payment amount needed to pay off your remaining balance by the loan maturity date, while taking into account the new interest rate and the need to maintain equal payments.
Yes. ARM loans have a rate limit indicating the maximum interest rate for the length of the loan, as well as the maximum amount your interest rate can increase with each adjustment.
Many homeowners choose an ARM to take advantage of the lower mortgage rates during the initial period. You may consider an ARM if you plan on moving or selling your home before the adjustment period of the loan, or if interest rates are high when you buy your home. Keep in mind that, with an ARM, there is uncertainty about how much your monthly payment will go up or down. Depending on the market, your rate could adjust upwards and increase your monthly payments.
- Adjustment Frequency: This refers to the amount of time between interest-rate adjustments
- Adjustment Indexes: Interest-rate adjustments are tied to a benchmark, in this case, the London Interbank Offered Rate (LIBOR)
- Margin: When you sign your loan, you agree to pay a rate that is a certain percentage higher than the adjustment index. For example, your adjustment rate may be the rate of LIBOR plus 2%. That extra 2% is called the margin.
- Caps: This refers to the limit on the amount the interest rate can increase each adjustment period.
- Ceiling: This is the highest that the adjustable interest rate is permitted to reach during the life of the loan.
A fixed-rate conversion feature allows the borrower to convert their adjustable-rate mortgage to a fixed rate without having to go through the expense of a refinance. The option to convert to a fixed rate is only available on the first, second, or third change date of the loan.