Real Estate Terms

Adjustable Rate Mortgage Definition

The interest rate in a mortgage can either be fixed or the one that keeps fluctuating throughout the term. With fixed-rate mortgages, the monthly payments remain the same, but in Adjustable-rate mortgages (ARM), the monthly payments keep changing. Whether the rate is fixed or adjustable can significantly impact the loan’s overall cost. In this post, I’ll explain how adjustable-rate mortgages can affect the mortgage and what you need to know if you’re preparing for a real estate exam.

What is an Adjustable Rate Mortgage?

An adjustable-rate mortgage is a home loan with a variable or fluctuating interest rate. Adjustable-rate mortgages are also known as floating or variable-rate mortgages because the interest rate changes over the term. Since the rates change throughout the term, the amount the borrower pays per month also changes. With ARMs, the interest rate is fixed for the initial period and then changes according to the market values. 

How Do Adjustable Rate Mortgages Work?

An adjustable-rate mortgage starts with a low-rate introductory period fixed for a few years. For instance, if a mortgage is of 30 terms, the interest rate will be fixed for five to ten years, and then it will be adjusted according to the market conditions. Most people prefer ARMs because of the low introductory rates, which make it easy to make monthly payments for a certain period. Once the initial interest rate expires, the rate will start fluctuating.

For some people, this can be difficult to manage or plan the monthly payments as there can be an unexpected increase or decrease. Interest caps are used to prevent rate hikes. These rate caps are represented in a 3-digit format. For instance, if the rate cap is 3/2/5, the mortgage has an initial cap of 3%, a periodic cap of 2%, and a lifetime cap of 5%. The following are the different types of rate caps:

Initial Adjustment Cap

After the introductory-rate period ends, the first adjustment rate begins, and the initial cap limits the rate’s increase. The initial cap describes the maximum amount that the interest rate can change in comparison to the initial interest rate. The initial cap is mostly 2% to 5%, which means that the interest rate can’t increase more than 2% to 5% than the initial interest rate.

Periodic Adjustment Cap

The periodic adjustment cap is also known as the subsequent adjustment cap. This rate cap describes how much the interest rate can change during the adjustment period. The periodic adjustment cap is 2%, meaning the interest rate can’t be more than 2% higher than the previous rate.

Lifetime Cap

The lifetime cap puts a limit on how much the interest rate can change throughout the entire mortgage. The lifetime cap is mostly 5%, which means that the interest rate during the entire term can’t increase more than 5% of the initial rate. For instance, if the initial fixed rate is 3% and the lifetime cap is 5%, this mortgage’s interest rate will not increase more than 8% during the entire term.

How Are Interest Rates Calculated for Adjustable Rate Mortgages?

Interest rates for ARMs are calculated according to the index and the ARM margin. After understanding how the rate cap works, homebuyers can better choose the type of ARMs that work best for them. The following are the two main factors that are used for calculating adjustable-rate mortgages:

Index

An index is a benchmark that indicates the market conditions. Mostly the index is determined by looking at the U.S Prime Rate or the Constant Maturity Treasury (CMT). The lender decides the index to be used with the loan when the borrower applies for a loan, and the choice of an index doesn’t change after closing.

Margin

Margin is the number that the lender sets for the adjustable-rate mortgage. It is in the form of percentage points that the lender adds to the index after the introductory period. Similar to the index, the margin is set in the loan agreement and doesn’t change after closing. The margin amount also depends on the lender and the loan amount.

Interest Rate

To calculate the interest rates, the index and margin are added. This interest rate is calculated after the introductory period of the fixed-interest rate is over. Once this period is over, the rate will be determined based on the market rates and not on your financial performance. This is the formula used for calculating the interest rate for ARM:

Interest Rate = Index + Margin

Common Types of Adjustable-Rate Mortgages

The adjustable-rate mortgages are expressed in a two-digits format. The first digit indicates the duration for which the initial fixed-interest rate will last. The second digit indicates the number of times the rate will adjust once the introductory period ends, it is also called the adjustment frequency. For instance, 1 means the rate will change once a year. If it is a 10/6 ARM, it means that the fixed-interest rate for the introductory period will last for ten years, and after that, it will adjust every six months. The following are the most common types of ARMs:

  • 5/1 ARM
  • 5/6 ARM
  • 7/1 ARM
  • 7/6 ARM
  • 10/1 ARM
  • 10/6 ARM

Besides these, lenders also offer 3/1 ARMs. If the buyer is willing to sell the home within a few years, an ARM with a shorter introductory rate period is a better option. The adjustable-rate mortgages are also classified according to the monthly payment schedule and overall payment structure; the following are the options:

Hybrid ARM

A Hybrid ARM is the most common type of adjustable-rate mortgage. This type of ARM starts with an initial period of fixed-interest rate. Once the period is over, after 3 to 10 years, the interest rate is adjusted according to a predetermined schedule. For instance, once a year or every six months.

Interest-Only ARM

Interest-Only ARM is the mortgage in which the borrower pays interest only for a particular period. Once the interest-only period is over, the borrower starts paying the interest and principal both as monthly repayments. The interest-only period can last a few months or years, during which the borrower can enjoy very low monthly payments. However, this also means that the borrower will build a minimal amount of equity during these years.

Payment-Option ARM

The payment-option ARM allows borrowers to choose their preferred payment schedule. For instance, they can choose between 15, 30, or 40-year terms or an interest-only ARM. If the borrower pays less amount that doesn’t cover the interest, the loan can result in negative amortization. Negative amortization means the borrower will have an increased loan balance.

Adjustable-Rate Mortgage vs. Fixed-Rate Mortgage

 Adjustable-Rate MortgageFixed-Rate Mortgage
Interest Rate-Changes throughout the term-Does not change throughout the term
Complexity-More complex because of changing rates-Easier to plan and make budgets
Benefits-Lower monthly payments during the first 3 to 10 years (introductory period)
-If the interest-rate decreases further after the introductory period, the result is even lower monthly payments
-Protects against the sudden increase of interest rates according to economic conditions
-Stable interest rates
-Predictable payments
Drawbacks-Higher monthly payments after the introductory period ends
-Unpredictable payments
-Difficult to qualify if the interest rates are too high
-High closing costs

Adjustable Rate Mortgage Examples

Example 1: Suppose Fred wants to purchase a property for $200,000, but his income is very low, and can’t afford to make monthly payments with a mortgage. A loan officer recommends applying for an adjustable-rate mortgage to benefit from the low-initial monthly payments due to the low fixed-interest rate. The mortgage term is 30 years and the introductory fixed-rate period is five years. The loan agreement includes the following details:

  • Mortgage amount: $200,000
  • Term: 30 years, 5/1 ARM
  • Fixed-interest rate: 4%
  • Introductory period: 5 years
  • Monthly payment: $954.83

Fred will have to pay $953.83 per month during the introductory period. This period will last for five years, after which the adjustment will be made once a year at a rate of 2%. After the increase in interest rate, Fred will have to pay the following:

  • Monthly payment: $1,199.10
  • Total payments: $605,717
  • Total interest: $405,717

Example 2: Suppose Sofia wants to purchase a home that costs $425,000. She has two options to choose from: a fixed-rate and an adjustable-rate mortgage. The following is a breakdown of the mortgage details for the two types of mortgages:

 10/1 ARM30-Year FRM
Mortgage Amount$425,000$425,000
Interest Rate4.24%6%
Monthly Payment$2090.74 for ten years, and then increases or decreases based on the new adjustment rate$2,548 for 30 years

After evaluating the two options, Sofia decided to choose the fixed-rate mortgage. She chose this because she wants to plan her budget and make fixed monthly payments throughout the mortgage term. On the other hand, she is sacrificing the low initial monthly payments with the ARM for 10 years. Since she knows the rate will change after 10 years with the ARM, she doesn’t want to take risks as she knows she won’t be able to afford more than $2,548 per month.

Frequently Asked Questions

What are the Advantages of Adjustable-Rate Mortgages?

Adjustable-rate mortgages offer lower initial interest rates for a fixed period, reducing the borrower’s monthly payments. This helps the borrower allocate more funds toward the principal. Besides that, another benefit is that ARMs have cap limits preventing interest rates from going too high.

What are the Disadvantages of Adjustable-Rate Mortgages?

Adjustable-rate mortgages are more difficult to understand than fixed-rate mortgages. Since the interest rate varies throughout the term, the monthly payments are re-calculated. Besides that, interest rates may rise, which increases the monthly payments. Even with the cap limit, sometimes the monthly payments can become unaffordable. Moreover, there is also a chance of a prepayment penalty with ARMs. A prepayment penalty is a fee the lender charges when the borrower pays more than the agreed periodic payment or pays off the entire mortgage before maturity.

Who Should Get an Adjustable-Rate Mortgage?

Adjustable-rate mortgages are suitable for those borrowers who find it challenging to make upfront or high initial monthly payments. With these ARMs, borrowers can enjoy low monthly payments for five to ten years. Besides that, these loans are a good option for those borrowers who don’t plan to stay permanently or for a long term in the house. For instance, the borrower can stay in the home during the introductory period when the monthly payments are low and then sell the home and use the proceeds to pay off the loan. If the borrower intends to stay permanently in the house, an adjustable-rate mortgage can be expensive as the rate will increase once the fixed-rate period is over.

What to Know for the Real Estate Exam

Adjustable-rate mortgages have interest rates that are adjusted throughout the term. The interest rates are fixed for an initial period, but after that, they are adjusted according to the market conditions. To maintain the percentage of increase in interest rates, these mortgages come with limit caps. These limits ensure that the rates don’t go higher than a certain limit compared to the introductory period. The borrower must consider various factors to choose between fixed-rate and adjustable-rate mortgages. For instance, whether the borrower wants to live in the house permanently or wishes to sell it soon, whether they will afford the monthly payments if the interest rate rises, and the maximum amount they can afford. There are lots of other real estate vocabularies you must go through to prepare for a real estate exam.

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