Adjustable rate mortgages, or ARMs, typically become much more popular when mortgage rates are on the rise. ARMs are a little more complicated than fixed-rate home loans, and not everyone is comfortable with them. You should learn to get comfortable with them, however, because they can save you a lot of money — in some cases, enough to pay for a new car in five years!

Why Choose an ARM?

ARMs are mortgages with interest rates that can change during their terms. The timing and calculation of adjustments (also called resets) are determined by the loan program, and these details are disclosed in your mortgage documents.

ARMs are offered at lower interest rates to borrowers willing to take on some of the lender’s risk. Those lower rates can provide ARM borrowers with a significant advantage, and in many cases, the added risk is never a factor — because the most popular ARMs have start rates that are fixed for three, five, seven or ten years. A borrower with a 5/1 $300,000 mortgage at 3.0 percent will pay $10,046 less over five years than a borrower with a 4.0 percent 30-year fixed loan.

ARM Terms

Borrowers should understand these common elements of ARMs completely before committing to an adjustable mortgage.

Start rate: This is also called the introductory rate, or teaser rate. The start rate is the interest rate used to calculate the first payment(s) the borrower will make. This start rate may be in effect from 30 days to ten years, depending on the loan terms. The most popular ARM is fixed for five years (it’s called a 5/1 ARM), and its start rate is usually about one percent lower than that of a 30-year fixed mortgage.

Introductory period: This is the length of time the start rate applies. Once the introductory period ends, the ARM begins resetting at regular intervals. For example, after five years, the introductory period of a 5/1 ARM expires and the loan’s interest rate will reset annually. The “5” in the loan’s name refers to the length of the start period, and the “1” refers to the number of years between resets once the loan begins adjusting.

Index: Adjustments to ARM loans are tied to movements in financial markets and the values of published financial indexes — they can be easily looked up online. Many ARMs, for example, are based on the London Interbank Offered Rate, or LIBOR. When it’s time for the loan’s rate to reset, the value of the index is added to another component, the margin, to create what’s called a fully-indexed rate.

Margin: The margin is set by the lender and agreed to by the borrower. It’s a percentage, for example, 2.5 percent, that’s added to the value of the loan’s index to come up with the fully-indexed rate.

Fully-indexed rate: This is the rate calculated when an ARM resets. It is determined by taking the value of the loan’s index and adding its margin. For example, if a loan based on the LIBOR index is adjusting in September 2014 and has a margin of 3.00 percent, its new rate equals 3.58 percent, because the value of the 1-year LIBOR at that time is .58 percent. However, that rate is subject to restrictions — caps and floors.

Lifetime cap, or ceiling: Almost all ARMs have caps which limit how high a rate can go during the loan’s term, regardless of what happens in financial markets or what the loan’s fully-indexed rate is. The cap can be expressed as a maximum interest rate or a maximum increase over the start rate (usually five or six percent). For example, a 5/1 ARM might start at 3.00 percent and have a ceiling of 9.00 percent (or six percent over its start rate).

Adjustment caps: ARM loans can have more than one type of cap. The initial adjustment cap limits the first rate adjustment. It may be expressed as an interest rate or a maximum increase. A 5/1 ARM might have an initial adjustment cap of three percent. The periodic adjustment cap is usually lower than the initial adjustment cap. The typical cap for a 5/1 ARM is two percent per year.

Rate floor: This is the lowest rate the loan can have, regardless of what happens in financial markets or what the loan’s fully-indexed rate is.

How ARMs Work

Suppose a lender offers you two loans — a fixed loan at 4.25 percent and a 5/1 LIBOR ARM at 2.875 percent. You expect to own your home for six years. To choose between both loans, you’ll need to understand how your ARM will behave. The first five years are easy — you’ll pay 2.875 percent. But what happens after that?

Look at your documents. In this case, the loan has a three percent cap on the adjustment that will take place in year six. So you know already the highest your rate will be in year six is 5.875 percent. And this loan has a three percent floor, so the lowest rate you’ll get in year six is 3.00 percent. What if your rate were adjusting today? A quick look at the 1-Year LIBOR rate shows that it’s at .78 percent. Your loan has a 2.5 percent margin, so if it were adjusting today, it’s fully-indexed rate would be 2.5 + .78, or 3.28 percent. Not bad. However, that doesn’t tell you what your rate is likely to be in five years. To get a better idea, check out this table, which shows the average value for several indexes. The 15-year average for the one-year LIBOR is 2.504 percent. Add your 2.5 percent margin to this, and you get 5.04 percent. In summary, your loan in year six would look like this:

  • Best case: 3.0 percent
  • Worst case: 5.875 percent
  • At today’s rates: 3.28 percent
  • At the average LIBOR: 5.04 percent

For many people, paying 2.875 percent for five years, and then 3.0 to 5.875 percent for one year is more attractive than paying 4.25 percent the entire time. On the other hand, if you think you might be keeping your home for ten years or longer, the ARM becomes significantly riskier, and that must be considered.

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