Adjustable-Rate Mortgages (ARMs) have an interest rate that fluctuates throughout the loan's life. The initial rate is typically lower than comparable fixed-rate offerings, which can make them more appealing. However, that interest rate will adjust - usually each year - after a predetermined amount of time. For example, a popular adjustable-rate offering is the 5/1 ARM. In a 5/1 ARM, the initial rate will last for 5 years. After 5 years, the rate will adjust each year.
How are interest rates determined?
Interest rates are unpredictable which can make this mortgage offering a calculated risk for borrowers. After the fixed-rate period ends, the interest rate will move up or down based on the index that it is tied to. Most rates are determined by the performance of three major indexes and can be impacted by economic conditions. The loan program and paperwork will identify the index for the individual mortgage.
The most popular indexes are:
1-year constant maturity Treasury (CMT): a popular mortgage index published by the Federal Reserve Board that represents the one-year yield of the most recently auctioned Treasury securities.
Costs of Funds Index (COFI): represents the weighted average interest expense paid by reporting financial institutions on their borrowings. Loans tied to this index tend to rise and fall more slowly than rates in general.
Secured Overnight Financing Rate (SOFR): a benchmark interest rate for loans which replaced the London Interbank Offered Rate or LIBOR. This index is published by the New York Federal Reserve every business day for the previous business day.
On top of the index, your lender will add an additional agreed-upon percentage or margin. This markup will not change over the life of the loan, unlike the index rate. The fully indexed rate is the sum of the index and the margin - this is the amount that will be applied to your monthly payments.
There are limits, or caps, to how much or little your interest rate can adjust. Speak with your lender directly about the various adjustment caps when comparing ARMs.
Why can they be popular?
ARMs can also be popular with home buyers that do not plan to stay in their home long-term or have a career that requires them to move frequently, such as the military.
Potential to lock in a lower initial interest rate.
Because the initial rate is usually lower than a fixed mortgage interest rate, an ARM might be a good option for those that do not anticipate staying in their home long-term and beyond the
initial fixed-rate period.
Interest rate has the potential to decrease when the rate resets.
Even if the rate rises, there is a limit or cap that rates can change.
Interest rates have the potential to rise to an uncomfortable level, even with the cap limit.
You can't predict your future finances. You may encounter unexpected medical expenses, unemployment, a change in marital status, etc.
Some mortgages could contain a prepayment penalty - where there's a fee and time restriction on when you can sell or refinance your home. Speak with your lender directly to learn how this might affect you.
If you're considering an ARM in the current market, we recommend speaking directly with your lender to answer any questions and learn how an adjustable-rate could affect - or benefit - you.