• Adjustable Rate Mortgage FAQs

    Brandon Cornett

    By Brandon Cornett
    © 2011 All rights reserved

    What is an adjustable-rate mortgage loan? How do they work? What are the pros and cons associated with these loans? When is it a good idea to use an ARM? You'll find answers to these questions and more in our collection of adjustable mortgage FAQs.

    1. What is an adjustable-rate mortgage loan?

    Also referred to as an ARM loan, the adjustable-rate mortgage is a home loan with an interest rate that changes periodically. This is vastly different from a fixed-rate mortgage, which carries the same interest rate for the entire life of the loan. With an ARM loan, the interest rate changes periodically in correlation to an index (such as the Cost of Funds Index, or the 1-year Treasury rate). The monthly payment may increase or decrease along with these rate changes.

    This is one of the first decisions you'll have to make as a home buyer and borrower. You'll have to decide if you want to use a mortgage loan with a fixed rate of interest, or a rate that changes over time. As we continue through this lesson, you'll begin understand the pros and cons of each option. Understanding these pros and cons is the key to making the right decision.

    2. How does an adjustable-rate mortgage work?

    There are different types of adjustable-rate mortgages, and they all behave in slightly different ways. But they share one thing in common. The interest rate on the loan will change with some kind of predetermined frequency.

    These days, most adjustable mortgages are considered hybrid loans. As you know, a hybrid combines two more more qualities in a single item (like a hybrid car that has an electric and gas-powered engine). A hybrid ARM loan starts off with a fixed rate for a certain period. After that period expires, the rate will start adjusting at a predetermined interval.

    The initial rate might remain fixed anywhere from one month to five years, and sometimes even longer. During this period, your monthly payments will stay the same as well (the ARM essentially works like a fixed-rate mortgage at this time).

    But after the initial fixed-rate period, everything changes. That's when the interest rate on the hybrid ARM begins to change. They usually change every year after the fixed phase has expired. For example, consider the 5/1 ARM (one of the most popular adjustable-rate mortgages). This loan starts off with a fixed rate for the first five years. After that, the rate will change every year. That's what the "5/1" numbers indicate.

    There's also a 3/1 ARM, a 7/1 ARM, and a one-year adjustable that only has a fixed rate for the first year.

    Here's the most important thing to understand about how the adjustable-rate mortgage works. The initial interest rate and payment can vary greatly from the rates and payments you have later on in the loan's term. By their nature, these loans are unpredictable. That's their biggest downside. You never know exactly how much your rate will rise over time. You might know what the first adjustment will be, but the years following that are something of a mystery.

    Adjustable-rate mortgage loans have limits or "caps" on the amount the rate can change. These days, most ARM loans have two types of caps:

    • Periodic adjustment caps limit how much the interest rate can go up or down from one adjustment to the next (after the first adjustment).
    • Lifetime caps limit the interest-rate increase over the life of the loan. Lifetime caps are required by law, so you'll find them on nearly all adjustable-rate mortgage loans.

    3. How do I figure the new rate on an adjustable mortgage?

    When you apply for an adjustable-rate mortgage, the lender may only quote you the initial rate and payment on the loan. But you need to ask about the annual percentage rate (APR). Rule of thumb: If the APR is a lot higher than the initial rate, your loan will likely adjust to a much higher rate and payment. This is something you need to understand, if you're going to use this financing method. The updated version of the Good Faith Estimate form will also tell you how much your rate might rise. So read that document carefully.

    4. What is a hybrid ARM loan?

    These days, most ARM loans actually start off with a fixed rate for a certain period of time. This is called a "hybrid" ARM loan. After the introductory period, the rate will begin to change periodically.

    5. What is a 5/1 adjustable-rate mortgage?

    The 5/1 adjustable-rate mortgage is a good example of a hybrid loan (see above). This type of ARM loan starts off with a fixed rate for the first five years. That's what the "5" indicates. After this initial 5-year period, the rate will begin to adjust once per year. That's what the "1" indicates. If you plan to use a 5/1 ARM, you should ask the lender how high your rate could increase in the sixth year. Ask about lifetime caps and periodic caps, as well.

    6. What is a 5/5 adjustable mortgage?

    It works the same as the 5/1 ARM loan described above, only the rate changes once every five years after the fixed-rate period. The first "5" indicates the initial five-year period when the rate is fixed. The second "5" tells you that the rate will adjust every five years, after the fixed period expires. 

    7. When is the adjustable-rate mortgage a good idea?

    If you're only going to be in a home for a few years (e.g., a temporary job assignment), you might want to consider using an ARM loan. You can probably get a lower interest rate than you would get with a fixed-rate mortgage. And if you sell the house before the first adjustment period, you won't encounter any risk or uncertainty.

    If you're planning to stay in the home for many years, you should seriously consider using a fixed-rate loan. You'll pay a higher interest rate, but you'll have a lot more certainty as well. Like I said earlier, it's all about weighing the pros and cons of each option. You have to choose the type of mortgage that matches your situation the best.

    8. How much of a down payment is required for an ARM loan?

    This will depend on the lender. The "old rule" for mortgage loans required you to put 20% down. This is still a good target, but it's not necessary in today's mortgage market. These days, most adjustable-rate mortgages require a minimum of 5% to 10% percent down. Just know that if you put less than 20% down, you'll have to pay for private mortgage insurance.

    9. Is it easier to qualify for an adjustable mortgage loan?

    The qualification standards are generally the same for both adjustable and fixed-rate loans. The biggest difference between them is the interest rate, and how it behaves over time.

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    There is certainly more to know about ARM loans than what's included in this article. If you have additional questions about this topic, you can do a search at the top of this page. You'll find hundreds more articles like this one on the website.

2011 Home Buyer's Guide