What Is An Adjustable Rate Mortgage?

Adjustable rate mortgages are also known as “ARM” loans. These are home loans with monthly payments that move up and down along with interest rates and the market. There’s different periods that occur throughout the time of the adjustable loan including an initial period where the rate is fixed for a certain amount of time. The rates will change along with preset intervals of change. 

Rates Start Lower Than Fixed Rate Mortgages

Interest rates during the fixed rate period of an adjustable mortgage are usually lower than that of fixed-rate mortgages. The most common type of adjustable rate mortgage is called the 5/1 ARM. This means that the rate is locked for a total of 5 years before it becomes truly adjustable. After the 5 years the rate will change every year. Other forms of ARM loans are the 3/1, the 7/1, and the 10/1.

Rate Indexes And Margins

Following the fixed-rate period, the interest rate adjusts with what’s titled the index interest rate. This rate is set by the market and is released periodically by an independent party. Since there are a variety of indexes, your loan will state which index your adjustable rate mortgage will follow. To set your exact rate, your lender will look at the index and then add a number of percentage points that has already been set in place. This is called the margin. For example, an index rate of 2.5 percent and a margin of 2 will equal an interest rate of 4.5 percent. As the index changes, this number will go up and down.

Adjustable Rate Mortgages Come With Caps

If you do decide to go with an adjustable rate mortgage, you should know that you’re protected from extreme rate increases. These loans come with caps that limit the amount that both rates and payments can change by. There are several different kinds of caps including:

Periodic Rate Cap

This limits the amount that an interest rate can change from one year to the next.

Lifetime Rate Cap

This type of cap limits how much the interest rate can change overall throughout the life of the loan. 

Payment Rate Cap

This limits how much the monthly payments can rise over the life of the loan in a dollar amount. This is different than other caps, since it denotes dollars instead of percentage points.

Is This Type Of Loan For You?

Adjustable rate mortgages can be good, depending on the state of the economy and your own financial situation. Stay educated and shop around in order to get the best rates available for you.