Adjustable & Fixed Rate Mortgage Loans
What is an Adjustable Rate Mortgage (ARM)?
If you’re looking for flexibility as well as a low rate that you can depend on for the first few years of homeownership, an adjustable rate mortgage might be a winning option. Many first-time homebuyers are partiucilarly attracted to ARMs due to the introductory “teaser” rates that are comparatively lower than those of exclusively fixed rate mortgages, thus reducing monthly payments and providing an affordable entry point to homeownership.
Simply stated, an adjustable rate mortgage is a mortgage that consists of two distinct elements:
- An initial fixed rate period (typically 5-, 7- or 10-year options) that features a low introductory rate.
- A variable rate period for the remainder of the loan that is based on an index rate, which measures the cost of short-term borrowing.
To arrive at the effective interest rate for your adjustable rate period, the ARM is then added to your lender’s pre-established margin (also a percent). This total is what you will pay during the ARM portion of the loan.
In a sense, all ARMs are actually hybrid mortgages, combining an upfront, fixed rate period with a (longer) back-end adjustable rate period.
How Does an ARM Mortgage Loan Work?
All ARMs begin with a fixed rate and they only begin to change once the allotted fixed rate period is over. Even then, they don’t change capriciously or with great frequency. Usually an ARM will either reset once a year or every 6 months. Increasingly, due to industry changes that we’ll talk about later, most mortgage providers have begun to offer ARMs that readjust every six months as they transition to the SOFR index as their preferred interest rate benchmark.
OK, so in the real world of 10/6, 10/1, 7/6, 7/1, 5/6 and 5/1 ARM options, what does this mean for your mortgage?
Let’s say you want to buy a $300,000 home and you’re considering an adjustable rate mortgage. As a first-time homebuyer, you may be attracted to the low interest rates that are prominently featured as part of the fixed rate portion of an ARM. Everything else being equal, low interest rates = low monthly payments. Sure, for risk averse individuals, a 30-year fixed rate has a strong appeal, but if you need to save money now and the initial rate for a 5/1 mortgage is cheaper than its 30-year fixed rate counterpart, you may be swayed by the savings of an ARM.
While mortgage rates can change from lender to lender, in today’s interest rate environment, it may be possible to receive an ARM that’s markedly lower than the corresponding rates of a 30-year fixed loan.
Types of Adjustable Rate Mortgages
Today, most ARM options can be divided into three loan term categories:
- 5-year ARM
- 7-year ARM
- 10-year ARM
Some lenders offer a 3/1 ARM, but for the purposes of this article, we’re only interested in the most frequently offered ARMs. This makes it easy to compare specific rates between lenders and determine if you’re getting the best deal possible.
As for the terms themselves, you may be wondering what the big deal is. After all, each of these loans feature comparatively low introductory interest rate periods and then transition to a variable rate phase. All true. But each loan contains slightly different rates, and because the fixed rate period differs, the time spent in the adjustable period on the back end of the mortgage also differs, potentially resulting in significantly higher or lower monthly payments for the remainder of the loan.
The 5-year ARM (5/6 or 5/1) is perhaps the most popular of the ARMs. This is mostly due to the fact that the 5-year ARM offers the best rates for the initial fixed rate period. The rates are comparatively lower than a 7- or 10-year ARM mainly because the lender needs to provide you with incentive to absorb the risk on the other end of the loan—the adjustable portion. For a 30-year mortgage, a 5-year ARM will result in 25 years on the back end of the loan if you don’t sell your home or decide to refinance into a conventional fixed mortgage.
The 7-year ARM (7/6 or 7/1) is the middle ground between the 5- and 10-year options. Its rates are not typically quite as attractive as the 5-year ARM, but are usually lower than the 10-year equivalent. A 7-year ARM will refund you 23 years in the adjustable rate period unless you decide to refinance or sell your home before the mortgage transitions to the variable rate period.
The 10-year ARM (10/6 or 10/1) provides the least risky option out of the three readily available adjustable rate mortgages. Because the initial fixed rate period is extended to a full 10 years, the ARM period is only 20 years long. While that’s still plenty of time for rates to fluctuate wildly and create uncertainty when it comes to monthly mortgage payments, it’s still a safer bet than the 5- or 7-year ARMs. The teaser period will also feature rates that are comparatively lower than a 30-year fixed rate mortgage.
Understanding Incexes, Margins & Caps
The adjustable mortgage rate does not by itself produce the interest rate that affects your monthly mortgage payments during the ARM period of your loan. There are other factors at play. To better understand ARMs, let’s take a look at financial indexes, margins and caps.
All adjustable rate mortgages are generated from an index rate, or benchmark, that is based on the cost of short-term borrowing between banks. For decades, the most widely employed index for ARMs was the London Interbank Offered Rate (LIBOR) index, which was based on the cost of borrowing between certain global banks. However, because the pool of data was dangerously small and prone to fraud and manipulation, inevitable scandals around price fixing emerged. Slowly but surely, the financial sector moved away from LIBOR and as of 2020, began to embrace the more transparent and risk-free alternative known as the Secured Overnight Financing Rate (SOFR) index. This is the reference rate primarily used to determine the adjustable interest rate. Still, this is only one part of your actual rate.
The adjustable rate that affects your monthly interest payment is not solely determined by the index rate. The index rate—from the SOFR benchmark, for example— is added to your margin, which is an agreed-upon percentage established when you obtain the loan, and together, these two components create the fully indexed interest rate. This is what you will pay during the ARM period of your mortgage. Margins are generally determined by the level of risk your loan presents and do NOT change over time. A good credit score and a clean financial slate put you in the best position to earn a favorable margin from your lender.
Caps are essentially limitations on your adjustable interest rate. They were introduced to protect borrowers from wildly excessive interest rate hikes. They exist in two forms:
- Annual/Semiannual Caps: These delineate how much your ARM can rise during each rate reset period, typically every six months or once a year depending on the relevant index. While this can change from lender to lender, this is typically around 2%.
- Lifetime/Initial Cap: When your ARM loan transitions from the fixed rate period to the adjustable rate period, a cap can help protect you from paying an exorbitant rate, should rates rise. Caps also exist over the lifetime of the loan. For example, many lenders install caps to protect the borrower from incurring no more than a 5% hike in interest over the entire life of the loan. Check with your lender to see what caps they offer on their ARMs.
Note: Caps (or floors) also exist to prevent you from paying zero interest rates should rates plunge to that level. This is a way to ensure that lenders receive adequate compensation for making loans no matter the interest rate environment.
ARM verses Fixed Rate Mortgages
If you had to boil down the difference between an ARM and a fixed rate mortgage, the one word that would be most applicable is “risk.” ARMs by their very nature are financial products vulnerable to shifts in market conditions—conditions that can’t be predicted five, seven or 10 years into the future. This uncertainty provides risk.
However, this uncertainty can also provide potential benefits. Since the future is unwritten, rates could just as conceivably drop as they could increase. Even if they stay flat or tick up a little, the built-in savings of the initial fixed rate period can result in lower overall payments than many fixed rate mortgages.
Conventional 15-year and 30-year fixed rate mortgage options are at the polar end of risk. They provide the homeowner with steady, consistent interest payments that do not change. They are great loans for the risk-averse individual.
Interestingly, while ARMs typically feature more attractive rates on the front end of their products, recent market conditions have significantly closed the gap so that fixed rate loans remain highly competitive even given the ARM’s low initial rate. Generally speaking, when interest rates are low, the argument for an ARM is more difficult to make.
ARM Pros & Cons
At this point, it should be clear that ARMs provide benefits as well as some potential risks.
- Upfront savings
- Lower rates that may allow you to “buy more home”
- Flexibility to get in and get out (before ARM period) by selling or refinancing
- Possibility of lower payments if interest rates fall
- During the ARM period, rates can rise dramatically (even given caps)
- Hard to understand compared to a conventional fixed-rate mortgage
- Since rates can rise or fall, it makes financial planning difficult
- Risk, risk, risk