What are Adjustable-Rate Mortgages?

Category ยท Loan Programs

Published on July 5, 2019

Adjustable-rate mortgages (or ARMs) are a type of home loan that are differentiated from standard mortgages by one key factor: your interest rate changes periodically. Your monthly payment could be one amount next month and then higher or lower the next. You will often receive a lower interest rate at the outset of your mortgage and, after a certain period of time, your interest rate begins to vary.

ARMs are also known as variable-rate and floating rate mortgages.

How does an adjustable rate mortgage work?

Adjustable-rate mortgages are typically expressed via two numbers in either an X/X or an X/XX format.

The first number indicates, in years, how long the initial fixed rate will be applied to the loan. The second number can be harder to decipher. It may indicate how many years the adjustable interest rate will be in effect following the end of the fixed rate. It could also indicate how often a variable rate will adjust once the fixed rate period ends.

Examples of Adjustable Rate Mortgage expressions:

A 4/26 ARM

  • Includes a fixed rate for four years
  • Will switch to a variable rate for the remaining twenty-six years

A 5/1 ARM

  • Includes a fixed rate for five years
  • Will switch to a variable rate (which adjusts every one year) for the remainder of the mortgage

A 5/6 ARM

  • Includes a fixed rate for five years
  • Will switch to a variable rate (which adjusts every six months) for the remainder of the mortgage

Sorting out the jumble of numbers becomes easy pretty quickly once you've got a feel for the basics. If one of these formats doesn't make sense, it's safe to assume that your lender is using one of the other two to express the terms of your mortgage.

What are the benefits of Adjustable Rate Mortgages?

  • Often have lower interest rates than comparable fixed-rate mortgages
  • Building equity is easier with lower rates
  • Rates can and do go down
  • You don't need to borrow for longer than you intend to stay in your home

What are Adjustable Rate Mortgage Caps?

Adjustable Rate mortgage (ARM) Caps are mortgage rate caps. Caps are intended to limit the extent to which your payments can change. Without these caps in place, your interest rate would be free to swing wildly from one end of the payment spectrum to the other-- not an ideal scenario.

Periodic, lifetime, and payment caps can all be put into place to help protect your funds and keep interest rates and payments in check.

It's important to know that different mortgage lenders offer different rate caps. Even if you've received quotes for the same initial interest rate with multiple institutions, it'll likely pay off to check the fine print and look into their caps. It's good policy to know how much your rate could change before signing any paperwork.

What are the three types of caps on ARMs?

The initial adjustment cap

This cap indicates how much your interest rate can increase during its first adjustment following the fixed-rate period. Oftentimes, it winds up being roughly two to five percent. If your initial adjustment cap is 4%, it means your new rate won't be able to go more than four percentage points higher than your initial rate.

Subsequent adjustment caps: periodic and lifetime rate caps

Periodic rate caps place a limit on how much your interest can vary from one year to the next. Lifetime rate caps work similarly to periodic rate caps. The only difference is that these caps determine how much your interest can climb over your loan's entire lifetime.

Payment caps

Unlike periodic and lifetime rate caps, which are percentage-based, payment caps are expressed in dollar amounts. They limit the extent to which your monthly mortgage payment can go up.

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