Adjustable-Rate Mortgage (ARM) Definition

What Is an Adjustable-Rate Mortgage (ARM)?

An adjustable-rate mortgage (ARM) refers to a term loan with an interest rate that can fluctuate over the term of the loan. This interest rate is based on an index, which reflects current market forces.

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How Does an ARM Work?

adjustable-rate mortgage coin

The interest rate of an adjustable-rate mortgage (ARM) changes[1] over the lifespan of the loan. While its interest rate is initially lower than a fixed-rate mortgage, one of the inherent risks of an ARM is that if market forces change, its interest rate may exceed that of a fixed-rate loan.

Whereas, the benefit of a fixed-rate loan is that the interest rate is locked in place. The nature of a fixed-rate loan provides a degree of financial certainty to the borrower because the payment amount will not change due to a fluctuating interest rate.

There are two common types of ARMs: standard and hybrid. A standard ARM has a variable interest rate from day one. By contrast, a hybrid ARM (which is what most people think of an ARM) has an initial fixed-rate period[2], after which the interest rate fluctuates based on a predetermined frequency of time.

Mortgage originators typically offer ARMs in terms of 30 years[3] and 15-years. The interest rate structure applied during an ARM’s lifespan is split into two periods:

  • An initial fixed-rate period. These initial fixed-rate years vary at 3, 5, 7, or 10 years, depending on the mortgage that a borrower has chosen or obtained.
  • Adjustment period. During this period, the interest rate can rise or drop based on changes in an ARM index.

Components of an ARM

adjustable-rate mortgage index

Hybrid ARMs typically have four components:

  1. Index
  2. Adjustment frequency
  3. Margin
  4. Cap

Here’s an explanation of each.

Index

Most ARM rates, whether standard or hybrid, are tied to the performance of a financial index. There are three common indexes used for ARMs[4]:

  • T-bills. The Federal Reserve Board tracks the weekly constant maturity yield of these debt securities. T-bill rates are often used in the eastern United States.
  • 11th District Cost of Funds Index (COFI). This is the interest rate that financial institutions in the western United States (particularly Arizona, California, and Nevada) pay on their deposit holdings.
  • The Secured Overnight Financing Rate (SOFR). The SOFR is the successor of the London Interbank Offered Rate (LIBOR), a global interest rate benchmark.

Depending on the lender, they may not always tie the interest rate to a market index and instead change it at their own discretion. This practice is sometimes called a discretionary ARM, although this is not available in the United States[5].

Adjustment Frequency

This is the length of time between the interest rate changes.

Margin

A margin is an additional percent tacked onto the interest. For example, an ARM agreement may include an interest rate tied to the SOFR and a 2% margin, which means the borrower needs to pay the interest rate as dictated by SOFR plus a 2% of that rate.

Unlike the interest rate in an ARM, a margin typically stays the same over the life of the loan[6].

Cap

A cap is the highest allowed amount the interest rate can increase in an adjustment period. There are three types of caps[7]:

  • Initial adjustment cap – the maximum amount an interest rate can increase for the first time.
  • Subsequent adjustment cap – the maximum amount an interest rate can increase per adjustment period.
  • Lifetime cap (also known as a ceiling) – the maximum amount an interest rate can increase over the life of the mortgage.

ARM Notation

adjustable-rate mortgage notation

Various types of ARMs (more specifically, hybrid ARMs) can be written in two numbers, such as 5/1 or 5/6. The first number indicates the length of the fixed-rate period, while the second indicates the frequency of the rate change within a year[8].

For example, a 5/1 30-year ARM means the borrower pays a fixed interest rate during the loan’s first 5 years. During the remaining 25 years, the interest rate will be revised once a year. On the other hand, a 5/6 30-year ARM will have the rate revised every six months after a five-year fixed rate.

Pros and Cons of ARMs

ARMs offer several advantages[9] and a few caveats to borrowers. Some of these benefits include the following:

  • Flexibility. An ARM benefits buyers who plan to relocate prior to the end of the initial fixed-rate period.
  • Potential savings. The lower rate of an ARM enables the borrower to pay more of the loan’s principal, provided there are no prepayment penalties in the mortgage contract. This can speed up the payment of the mortgage and therefore save money.
  • Possibility of refinancing. Declining interest rates in the market can offer favorable conditions for a refinance or enable the borrower to capture a lower rate as their ARM adjusts lower.
  • Protection from steep rate fluctuations. ARMs have a feature that limits the increase or decline in a single period during the loan’s lifetime.
    Conversion option. Some lenders allow ARM borrowers to convert into a fixed rate after the introductory period, though with some additional charges.

On the other hand, ARMs can have far-reaching consequences. For example, the Great Recession was partly triggered by massive defaults in two-year subprime ARMs[10]. Some ARM disadvantages that borrowers need to look at closely include the following:

  • Possibility of inflated loan payments. Rising interest rates can make ARM payments unmanageable for a borrower after the fixed-rate period, raising the possibility of default.
  • Uncertainty. Entering into an ARM can be a gamble because its flexible rates hinge on market benchmark rate movements, which are difficult to predict.
  • Risk on a borrower’s household budget. An ARM borrower’s overall financial stability becomes vulnerable to market uncertainties.
    Complicated contracts. Complicated provisions, like those on rate cap fluctuations, refinancing, and repayment, have to be carefully weighed in an ARM contract.

Takeaways

  • An adjustable-rate mortgage is a loan with a fluctuating interest rate. This interest rate is tied to a financial index, such as SOFR or T-bill yields.
  • ARMs usually come in standard or hybrid types, the last so-called because it has an initial period where the interest rate does not change.
  • An ARM can be an ideal choice for borrowers who plan to live in their mortgaged house for a short time and can afford any potential increases in their interest rate.
  • Interest rate declines in ARMs’ benchmark indexes can work in the borrowers’ favor, such as allowing them to refinance their mortgage.

Sources

  1. Kagan, J. (2021.) What Is an Adjustable-Rate Mortgage (ARM)? Investopedia. Retrieved from https://www.investopedia.com/terms/a/arm.asp
  2. Highlander Mortgage. (n.d.) Standard ARMs and Hybrid ARMs. Retrieved from https://www.highlandermortgage.com/loan-options/featured/standard-arms-and-hybrid-arms/
  3. Miranda, C. (2021.) What Is an Adjustable Rate Mortgage? Rocket Mortgage. Retrieved from https://www.rocketmortgage.com/learn/adjustable-rate-mortgage
  4. Quicken Loans. (2020.) What Is an Adjustable Rate Mortgage? Retrieved from https://www.quickenloans.com/learn/understanding-adjustable-rate-mortgages-arm-basics
  5. The Mortgage Professor. (2011.) Peace of Mind With an Adjustable Rate Mortgage? Retrieved from https://www.mtgprofessor.com/A%20-%20ARMs/can_you_have_peace_of_mind_with_an_arm.htm
  6. Johnson, J. (2021.) What Is ARM Margin? The Balance. Retrieved from https://www.thebalance.com/what-is-arm-margin-5200832
  7. Ostrowski, J. (2021.) Adjustable-rate Mortgages: Learn the Basics of ARMs. Bankrate. Retrieved from https://www.bankrate.com/mortgages/basics-of-adjustable-rate-mortgages/
  8. The Federal Reserve Board. (n.d.) Consumer Handbook on Adjustable-Rate Mortgages. Retrieved from https://files.consumerfinance.gov/f/201204_CFPB_ARMs-brochure.pdf
  9. Lamberg, E., Cetera, M. (2020.) When an Adjustable-Rate Mortgage Is the Best Choice. Forbes Advisor. Retrieved from https://www.forbes.com/advisor/mortgages/adjustable-rate-mortgage/
  10. Pogol, G. (2018.) ARM Mortgage in 2021: No Longer the Wallflowers. The Mortgage Reports. Retrieved from https://themortgagereports.com/24709/arm-mortgage-in-2017-no-longer-mortgage-wallflowers
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