Adjustable-Rate Mortgage (ARM)

The previous lesson covered the most common mortgage option - the fixed-rate mortgage. This lesson covers the second most common mortgage option - the adjustable-rate mortgage (ARM).

Adjustable-Rate Mortgage

The adjustable-rate mortgage (also known as a variable-rate mortgage or as an ARM) has the following attributes.

The interest rate is not fixed; rather, it can increase or decrease over the life of the loan, based on market conditions.
The amount of change in the interest rate is often based on an index selected by the lender (e.g., yields on one-year or six-month U.S. Treasury securities).

Many adjustable-rate mortgages have rate caps that limit how much the interest rate can change. Most ARMs have periodic caps and lifetime caps. Periodic caps limit the increase from one adjustment period to the next. Lifetime caps limit the overall interest rate increase over the term of the loan. Limits of 2 percentage points per year and 6 percentage points over the life of the loan are typical.

Warning

Some adjustable-rate mortgages seem attractive because they have very, very low initial interest rates. However, they may also have very high lifetime caps or costly penalty fees that make it expensive to refinance. It is easy for an unwary buyer to commit to an ARM that he/she cannot afford after only a few rate adjustments.

The table below shows how interest rates vary for different types of adjustable-rate mortgages (ARM's).

Type of ARM	Interest Rate
10/1 ARM	Fixed for 10 years (120 payment periods) Adjusts each year thereafter, until the loan is paid off.
7/1 ARM	Fixed for 7 years (84 payment periods) Adjusts each year thereafter, until the loan is paid off.
5/1 ARM	Fixed for 5 years (60 payment periods) Adjusts each year thereafter, until the loan is paid off.
3/1 ARM	Fixed for 3 years (36 payment periods) Adjusts each year thereafter, until the loan is paid off.
1-year ARM	Fixed for 1 year (12 payment periods) Adjusts each year thereafter, until the loan is paid off.

Variations on the Adjustable-Rate Mortgage

Adjustable-rate mortgages come in many other flavors. Here are a few.

Convertible ARMs. A convertible ARM is a type of adjustable-rate mortgage that allows the borrower to convert the ARM to a fixed-rate mortgage within a specified time period. Lenders often charge a premium for a convertible ARM, so you need to find out the exact terms and costs in order to evaluate this option.
Two-step mortgages. The two-step mortgage is a type of adjustable-rate mortgage that "adjusts" one, and only one, time. Typically, a two-step mortgage has one interest rate for the first 5, 7, or 10 years of the loan and a different interest rate for the remainder of the loan. The lender sometimes has the option to call the loan due with 30 days notice prior to the adjustment.
Balloon loan ARMs. Like the fixed-rate balloon loan, a balloon loan ARM is paid off as a lump sum (the balloon) before the loan is fully amortized. Unlike the fixed-rate balloon, however, the mortgage payment is not fixed. It can vary from one month to the next, just like any other adjustable-rate mortgage.
Interest-only ARMs. Like the fixed-rate interest-only loan, an interest-only ARM requires only monthly interest payments. Like a traditional adjustable-rate mortgage, it often has an initial period when the interest rate is fixed, followed by periodic adjustments. The main advantage of this loan is its initial low monthly mortgage payments. The main disadvantage is that it does not reduce the loan principal.
Graduated-payment mortgages. A graduated-payment mortgage offers a very low initial interest rate. Then, each year over the first 3 to 5 years, the interest rate is increased. After that initial period, the interest rate remains constant over the remaining term of the loan. Be aware that the initial years of this loan are often characterized by negative amortization.

Adjustable-Rate Mortgages: Dealing With Uncertainty

A key attribute of adjustable-rate mortgages is uncertainty. At some point during the term of the loan, the interest rate will change. Further, the amount and direction of change is uncertain.

This uncertainty presents a challenge for mortgage analysis. How can we estimate the total cost of an adjustable-rate mortgage when we don't know the future interest rate? Here are two ways to deal with this challenge.

Worst-case scenario. Even though we don't know what the exact interest rate will be in the future, we may know the maximum interest rate. The maximum rate is defined by periodic rate caps and maximum rate caps. The worst-case scenario assumes that the interest rate takes on its maximum value in every payment period.
Best-guess scenario. In this scenario, the analyst makes a guess about the average interest rate during the term of the loan. For the analysis, one assumes that the average interest rate will be somewhere below the maximum rate.

Each approach has advantages and disadvantages. Because the worst-case scenario overestimates the true cost of an adjustable-rate mortgage, the home buyer will never be surprised by a larger-than-expected bill. On the other hand, someone who uses the best-guess scenario may generate a more accurate estimate of the true cost of the mortgage, if he/she guesses right about the average mortgage rate. However, there is always the danger of guessing wrong and underestimating the true cost.

All of the examples on this website use the worst-case scenario to estimate costs for adjustable-rate mortgages.