Adjustable-Rate Mortgages (ARMs)

An adjustable-rate mortgage (ARM) has an interest rate that can change at certain points throughout the term of the loan. Most ARMs offer a fixed rate for a certain period of time (3, 5, 7, or 10 years), after which the rate adjusts to match current interest rates. Whenever the interest rate adjusts, the amount of your monthly payment will increase (if interest rates rise) or decrease (if interest rates fall). Like fixed-rate mortgages, ARMs usually come with 15- or 30-year terms. At the end of the term, you will have paid off the original principal plus interest. The total amount of interest that you pay on the loan will vary based on:

• Interest-rate fluctuations throughout the life of the loan
• The terms of the loan, such as how often it adjusts

The following table shows the main advantages and disadvantages of adjustable-rate mortgages.

How the Interest Rate of an ARM Adjusts

The rate index and margin determine how the interest rate of an ARM adjusts after the fixed-rate term expires.

• Rate index: An ARM’s interest rate is tied to one of several rate indexes, such as the interest rates of U.S. Treasury bills or CDs. When the interest rate of the reference index upon which a particular ARM is based rises or falls, so does the interest rate of that ARM. If you’re comparing the index rates of two ARMs, be sure that the loans are based on the same index. The index rate is the interest rate of the ARM, not including the margin (explained below).
• Margin: The markup that the lender adds to the index rate. The sum of the index rate and markup is called the fully indexed rate. Most lenders add a margin of 2–4%, which means that an ARM with an index rate of 5% would likely have a fully indexed rate of 7–9%.

If you’re shopping for an ARM, always be sure you’re evaluating the fully indexed rate of a loan, not just the index rate. Also, be wary of loans with teaser rates—introductory interest rates that are usually much lower than the loan’s fully indexed rate but often last as little as one month. Ignore teaser rates entirely and focus on the rate that takes effect once the fixed-rate period of your ARM ends.

Other Characteristics of ARMs

There are a few other key terms you should know as you begin to consider getting an ARM:

• Adjustment frequency: Once the fixed-rate term expires, ARMs adjust interest rates at certain intervals: some loans adjust every month, while others adjust semiannually, annually, or every few years. If you’re comparing two ARMs, the one that adjusts less often is the better choice, assuming that all other factors are equal.
• Caps: Caps are limits on the amount that an ARM’s interest rate can adjust from one interval to the next, as well as on the total amount that an ARM’s rate can adjust over the life of the loan. For instance, an ARM may have a 2/6 cap, meaning that the rate can increase or decrease no more than 2% in any adjustment period, and that it can increase or decrease no more than 6% in total over the term of the loan. If you’re comparing two similar ARMs, the one with stricter caps is usually the better choice. Never choose an ARM that doesn’t provide a cap on the loan’s maximum interest rate.
• Convertibility: Convertibility is a feature that enables you to convert an ARM into a fixed-rate mortgage. Convertible ARMs usually have relatively high fully indexed rates in comparison to other ARMs.

Interest-Only ARMs

An interest-only mortgage is a variation of an ARM that minimizes monthly payments by letting you pay only interest— not principal. Interest-only loans usually allow you to pay a fixed, low, interest-only payment for a set period of time—typically 5, 7, or 10 years on a 30-year term loan. After the period of fixed interest-only payments ends, these loans convert to regular ARMs with rates that adjust according to the terms of the specific loan. When the interest-only period of any interest-only loan expires, you have two choices:

• Pay off the entire balance in a lump sum: This option typically requires a cash payment of tens or hundreds of thousands of dollars.
• Start paying off the principal within each monthly payment: This option causes monthly payments to rise dramatically, even if interest rates don’t rise. If interest rates do also rise, monthly payments could skyrocket.

The Drawbacks of Interest-Only Loans

Never choose an interest-only loan as a way to buy a home that you could otherwise not afford. If you do, you probably won’t be able to afford the higher payments that will take effect after your interest-only term expires.

Perhaps the only reason to choose an interest-only loan is if you definitely intend to sell the property before the interest-only term expires and you don’t want to invest more money in your home than the amount of your down payment. Even if you choose an interest-only loan for this reason, you should still be aware of the following drawbacks of these loans:

• Limited equity growth: Equity is the difference between your home’s market value and the principal that you still owe on the mortgage. With an interest-only loan, your monthly payments don’t contribute toward paying down your principal, so your equity can grow only if your home rises in market value.
• Potentially higher payments: Even if you plan to sell before your interest-only term expires, you won’t necessarily be able to sell right away. If you can’t sell—due to factors such as a soft real estate market or an economic downturn—you’ll be stuck paying higher monthly payments until the property sells.