Description

An adjustable-rate mortgage (ARM), also known as a variable-rate mortgage, is a type of home loan where the interest rate can change over time based on predetermined factors. Unlike a fixed-rate mortgage, where the interest rate remains constant, an ARM’s interest rate typically starts with a fixed period of time and then adjusts periodically according to specific market conditions.

Here’s how an adjustable-rate mortgage works:

1. Initial Fixed Period: When you take out an ARM, you’ll usually have an initial fixed-rate period, often lasting for a few years (e.g., 5 years or 7 years). During this period, the interest rate remains stable and doesn’t change. This initial fixed-rate period offers borrowers predictable payments and can often come with lower interest rates compared to fixed-rate mortgages.
2. Adjustment Period: After the initial fixed-rate period ends, the ARM becomes “adjustable.” The interest rate is now subject to change based on the terms of the loan. The adjustment period could be every six months, one year, or another predefined interval, depending on the specific ARM program.
3. Index and Margin: The new interest rate during an adjustment period is determined by two main components: an “index” and a “margin.” The index is a benchmark interest rate, such as the London Interbank Offered Rate (LIBOR) or the U.S. Treasury Bill rate. The margin is a fixed percentage that the lender adds to the index rate to determine the new interest rate. For example, if the index rate is 3% and the margin is 2%, the new interest rate would be 5%.
4. Interest Rate Cap: To protect borrowers from excessive interest rate increases, ARMs usually have interest rate caps. These caps limit how much the interest rate can change during a single adjustment period or over the life of the loan. There are typically two types of caps: a periodic adjustment cap and a lifetime cap.
5. Payment Changes: When the interest rate adjusts, your monthly mortgage payment will change accordingly. If the rate increases, your payment will go up, and if the rate decreases, your payment will go down. This can make budgeting more challenging compared to a fixed-rate mortgage.

ARMs can be beneficial for borrowers who expect to sell or refinance their home before the initial fixed-rate period ends, or for those who anticipate interest rates to decrease in the future. However, they do carry a degree of uncertainty, as market fluctuations can lead to higher interest rates and potentially higher monthly payments over time.

Before choosing an ARM, it’s essential to understand the terms, including how often and by how much the rate can adjust, as well as the specific caps in place to protect against significant rate increases.