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Adjustable-rate mortgages are given their “adjustable” labels to differentiate them from fixed-rate loans. They are commonly referred to as ARM loans for short, and they come in several varieties. In this lesson, we will examine the basic components of an adjustable-rate mortgage. Then we will discuss the pros and cons associated with these loans.

Definition: So what is an adjustable-rate mortgage? An ARM is a home loan with an interest rate that fluctuates along with the up or down movements of a certain benchmark or “index.” Because the interest rate changes over time, the monthly payments can change as well.

This is what separates the adjustable-rate mortgages from their fixed-rate counterparts. A fixed loan carries the same interest rate for the entire financing term.

There are four main components of an adjustable mortgage: (1) an index, (2) a margin, (3) interest rate caps, and (4) an initial interest rate period. When the initial period expires, the new interest rate will be determined by adding a “margin” to the index. When you apply for one of these loans, the lender should disclose the margin to you. As a borrower, you want the lowest margin possible.

According to the Federal Reserve’s Consumer Handbook on Adjustable-Rate Mortgages:

“To set the interest rate on an ARM, lenders add a few percentage points to the index rate, called the margin. The amount of the margin may differ from one lender to another, but it is usually constant over the life of the loan.”

‘Hybrid’ Adjustable Mortgages

These days, most adjustable-rate mortgages start off with a fixed rate of interest, for a certain period of time. They are commonly referred to as “hybrid” ARMs, because they combine the features of two different loan products.

During this initial phase, the interest rates are typically lower than they are for comparable fixed mortgages. This is what makes the ARM loan appealing to home buyers in the first place. They start off with a lower rate, giving borrowers a way to reduce their monthly payments. But at some point, the rate will begin to adjust following the up or down movements of a certain benchmark.

The 5/1 ARM loan is the most popular type of adjustable-rate mortgage in use today. As the numbers imply, this type of loan starts off with a fixed interest rate for the first 5 years. After that, the rate will adjust annually, or every 1 year.

Adjustable-rate mortgages come in other “flavors” as well. Other popular hybrid ARMs include the 3/1, the 7/1, and the 10/1 adjustable mortgages. With all of these products, the first number indicates the length of the fixed-rate period. The second number (the 1) indicates the number of years between adjustments, after the fixed period expires. For example, a 7/1 ARM loan will have a fixed interest rate for the first seven years of the term. After that, the rate will begin to adjust every year.

These days, most adjustable-rate mortgages are tied to the fluctuations of a certain index. The three most common indexes include:

  • The Constant Maturity Treasury (CMT) index; the weekly constant yield on the one-year Treasury bill
  • The 11th District Cost of Funds Index (COFI)
  • London Interbank Offered Rate (LIBOR)

Here’s what you need to take away from this, as a borrower. Your adjustable-rate mortgage will be influenced by external factors that are beyond your control. These factors are also unpredictable. You don’t know whether these indexes will rise or fall over the coming months and years, or by how much they will rise or fall. This makes the ARM less certain and more risky, when compared to a fixed-rate loan.

Most ARM Loans Have Caps

There are limits to how much the interest rate can change from one adjustment to the next, and also over the life of the loan. These are known as “caps.” The caps on an adjustable-rate mortgage give you, the borrower, a certain level of protection from extreme rate hikes. So when shopping for an adjustable-rate mortgage, you must always ask the lender about caps.

There are different types of caps associated with ARM loans. These include:

  • Initial Adjustment Rate Cap – As the name implies, this puts a limit on how much the interest rate can rise during the first adjustment period. This cap can be expressed as a percentage. For instance, it might limit the first adjusted rate to being no more than 2% or 3% higher than the initial rate.
  • Rate Adjustment Cap – Limits the amount the rate can increase during any given adjustment, after the first adjustment.
  • Lifetime Cap – As the name implies, this places a limit on how much the interest rate can increase over the full life or term of the loan.

Here’s what you need to know, as a borrower. Caps remove some of the uncertainty associated with adjustable-rate mortgages. They give you a sense of where the ceiling might be, from one phase to the next. It is your responsibility to ensure you could afford the revised monthly payments at the maximum capped level, because there’s a possibility the rates and payments could rise that high. If you cannot afford the potential maximum increase, you cannot afford the ARM loan.

Part 2: Pros and Cons

This article answers the question: What is an adjustable-rate mortgage loan? The purpose of this article is to offer a basic definition. If you would like to know about the pros and cons of these mortgages, when compared to their fixed-rate counterparts, please continue to part 2 of this lesson.