If you want to take advantage of a lower initial rate, then consider an adjustable rate mortgage (ARM)
Commonly referred to as a “variable rate mortgage” or a “floating rate mortgage”, an adjustable rate mortgage (ARM) is a loan where the interest rate varies according to an external benchmark (such as the 12 month MTA index which is currently 0.285%). The initial interest rate is typically fixed for a set period after which the interest rate adjusts periodically, such as every month or every six months.
For example, a 2/28 ARM has an initial interest rate that is fixed for two years and then a floating rate for the remaining 28 years of the mortgage.
After the initial rate period ends, the ARM interest rate shifts up and down based on the index, which is another interest rate set by market forces.To determine the ARM rate, the lender takes the index rate and adds on a margin.
What are the pros and cons for ARMs?
- Lower initial rate. Generally the initial interest rate of an ARM is lower compared to a fixed-rate mortgage. If you only plan to stay in your home for a short amount of time, you can benefit from a lower initial interest rate because you may vacate your home before the initial rate period adjusts.
- Benefit from rate decreases. If interest rates fall, you will benefit from making lower monthly payments which can make your mortgage more affordable.
- Rate cap protection. Many ARMs have an interest rate cap which places a limit on how much the interest rate can increase by, which protects you from steep rate increases.
- Long fixed interest period. If the initial rate period is lengthy, you may be able to treat it as an effective fixed rate. For example, a 7/1 ARM gives you sufficient time to sell the property or refinance without your initial rate ever adjusting. This long fixed interest term means you can save money through lower closing costs throughout the initial period.
- Qualify for larger amount. As the initial payment is often lower compared to a fixed-rate mortgage, an ARM can maximize your home buying power as it can be easier to qualify for a larger loan amount.
- Market risk. After the fixed-rate period ends, the interest rate can rise which could mean that your monthly payments become more expensive after the initial period ends.
- Difficult to budget. As interest rates are unpredictable, you can’t predict what your monthly payments will be after the initial period, which can make it difficult to manage your cash flow.
- Difficult to refinance. If interest rates increase, this will not only make your payments more expensive but it will reduce the amount of equity you have in your home which can make it difficult to refinance with another lender.
- Complexity. The structure of ARMs can be difficult to understand for many borrowers when considering the margin, caps, indexes and fees, so unsavvy borrowers may find it difficult to compare ARMs effectively.
Who are ARMs suited to?
Generally ARMs are most suited to borrowers that are:
- Comfortable with a degree of risk. Borrowers must understand that their rate may increase after the initial period and that this will affect their monthly payments. While difficult to predict, an ARM may be useful if you believe interest rates are likely to fall in future.
- Holding property for short period. ARMs are suited to borrowers who only intend to hold their property for a short period of time as this means they can take full advantage of a lower initial rate. ARMs are also useful for borrowers who expect their income to rise in future as this may offset the higher payments following the adjustment period.
- Low initial rate benefit. This type of mortgage is suitable for borrowers who want to benefit primarily from a lower initial rate and lower monthly payments for short-term cash flow benefit.
What are the different types of ARMs?
- Hybrid ARMs. These loans are a mix of fixed-rate period and an adjustable-rate period. The interest rate is fixed for an initial period, such as for 7 years in a 7/1 ARM loan, and after this period, the rate may adjust annually until the loan is paid off.
- Interest-only (I-O) ARMs. An I-O loan allows you to pay only the interest portion of your loan for a set period, normally 3-10 years. This allows you to make smaller monthly payments over an introductory period as you are only paying the interest portion of the payment, and not the principal. After this time, your monthly payment will increase as you start paying back both the principal and interest.
- Payment-option ARM. This is a type of ARM that allows you to select a particular payment option each month, such as a traditional payment of principal and interest, an interest-only payment or a minimum payment. A minimum payment may be less than the amount of interest due that month. Keep in mind that a minimum payment can in turn increase the amount you owe on the loan.
What is the annual cap?
The annual cap restricts the potential increase in the ARM interest rate to a specified amount each year. This is designed to protect borrowers against a substantial increase in payments if the rates increase.
An ARM with an annual cap will only increase by a certain level in terms of percentage points irrespective of how much rates actually rise. For example, a 3% ARM with a 2% cap can only adjust to 5%, even if interest rates increase by 6% during the initial fixed term of the mortgage.
What is the difference between an ARM and a fixed-rate mortgage?
The primary difference between an ARM and a fixed-rate mortgage is that with a fixed-rate mortgage the interest rate remains consistent throughout the life of the loan, while with an ARM the interest rate moves up and down in relation to an index.
In addition, lenders generally charge lower initial interest rates for ARMs compared to fixed-rate mortgages.
How can I interpret ARM rates?
The most popular ARM is 5/1 which has an introductory rate for five years. After this period, the interest rate can adjust once per year. Other common fixed rate periods for ARMs are 3/1 and 7/1.
If you have trouble interpreting the different rate periods for hybrid ARMs, keep this in mind: the first number represents how long the fixed interest-rate will be, and the second number represents how often the rate will adjust after the initial period. For example, for a 7/1 ARM, the initial fixed-rate period is 7 years and after this time, the rate will adjust on an annual basis.
You may also see some ARMs which are expressed as 2/28 or 3/27. When represented this way, the first number tells you how many years the initial fixed rate period will be and the second number tells you the number of years the adjustable rate period will be.
Frequently asked questions
What is negative amortization?
Negative amortization is an increase in the principal balance of a loan caused by making payments that don’t cover the interest due. The remaining amount of interest owed is then added to the loan’s principal balance.
What is the margin on an adjustable rate mortgage?
A margin is a fixed percentage rate that you add to your index rate to obtain the fully indexed rate for an adjustable-rate mortgage.
Can I refinance my adjustable rate mortgage into a fixed rate mortgage?
Yes you can. Some people choose this option when they expect that the economy will improve in the next year or two.