What is an Adjustable Rate Mortgage?
Unlike fixed rate mortgages that have an interest rate that remains the same for the life of the loan, the interest rate on an adjustable rate mortgage (ARM) will change periodically. The initial interest rate of an ARM is lower than that of a fixed rate mortgage, consequently, an ARM may be a good option to consider if you plan to own your home for only a few years; you expect an increase in future earnings; or, the prevailing interest rate for a fixed rate mortgage is too high.
An ARM has four components:
(1) an index,
(2) a margin,
(3) an interest rate cap structure, and
(4) an initial interest rate period.
When the initial interest rate period has expired, the new interest rate is calculated by adding a margin to the index. Your lender will disclose the margin at time of loan application (margins may vary from lender to lender, so it’s a good idea to shop around for a low margin). As the index figure moves up or down, your interest rate will be adjusted accordingly. Acceptable index options on FHA insured ARM loan transactions are 1) the Constant Maturity Treasury (CMT) index (weekly average yield of U.S. Treasury securities, adjusted to a constant maturity of one year); or 2) the 1-year London Interbank Offered Rate (LIBOR). Increases or decreases in the interest rate will be limited by the interest rate cap structure of your loan.
The interest rate cap structure provides some protection from large interest rate swings. There are two types of caps:
(1) annual, and
(2) life-of-the-loan. The annual cap restricts the amount your interest rate can change, up or down, in any given year, while the life-of-the-loan cap limits the maximum (and minimum) interest rate you can pay for as long as you have the mortgage. FHA offers a standard 1-year ARM and four “hybrid” ARM products. Hybrid ARMs offer an initial interest rate that is constant for the first 3-, 5-, 7-, or 10 years. After the initial period, the interest rate will adjust annually. Below are the different interest rate cap structures for the various ARM products:
- 1- and 3-year ARMs may increase by one percentage point annually after the initial fixed interest rate period, and five percentage points over the life of the Mortgage.
- 5-year ARMs may either allow for increases of one percentage point annually, and five percentage points over the life of the Mortgage; or increases of two percentage points annually, and six points over the life of the Mortgage.
- 7- and 10-year ARMs may only increase by two percentage points annually after the initial fixed interest rate period, and six percentage points over the life of the Mortgage.
Learn more on our Mortgage 101 page.