90% of first-time home buyers use a 30-year fixed-rate mortgage to finance their home. Another ten percent use adjustable-rate mortgages (ARMs).
ARMs are a standard, regulated mortgage product. They’re not bad or dangerous or hostage-to-escape types. For many first time buyers, choosing ARM vs. Fixed is more appropriate.
This article discusses ARMs, what they are and how they work.
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What is an adjustable-rate mortgage?
An adjustable rate mortgage (ARM) is a home loan whose interest rate can change over time.
Adjustable-rate mortgages are available for:
- conventional mortgage
- FHA mortgage
- VA mortgage
ARMs are not available for USDA mortgages and some credit union mortgage products.
Adjustable-rate mortgages are 30-year loans with standard eligibility requirements. Lenders verify income, payment history and credit scores as part of adjustable-rate mortgage approval.
ARMs are available as low- and no-down payment mortgages.
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fixed vs adjustable rate mortgage
ARMs are similar to fixed rate mortgages. Both ARM and Fixed Rate Loans:
- Pay in 30 Years or Less
- Follow standard mortgage approval guidelines
- Get Online Underwriting & Approval
Adjustable and fixed-rate mortgages can finance any residential property, including standalone houses, condos, townhomes, multi-units and manufactured homes.
The difference between an ARM and a fixed-rate mortgage is that ARM mortgage rates can change over time, while fixed-rate mortgage rates cannot. Home buyers using an ARM share the risk with the bank and, therefore, receive more favorable loan terms such as lower overall rates.
According to Freddie Mac, ARM interest rates are an average of 0.64 percentage points lower than 30-year fixed-rate mortgages, an annual savings of $450 per $100,000 borrowed.
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How much can you save with a 5 year ARM?
This table compares ARM and 30-year fixed payments at today’s mortgage rates.
| loan size | annual savings |
| $75,000 | $601.84 |
| $100,000 | $802.45 |
| $125,000 | $1003.06 |
| $150,000 | $1,203.68 |
| $175,000 | $1,404.29 |
| $200,000 | $1,604.90 |
| $225,000 | $1,805.52 |
| $250,000 | $2,006.13 |
How do ARM loans work?
Adjustable interest rates are an optional mortgage loan feature.
Because their interest rates can change over time, adjustable-rate mortgages are strictly regulated. Regulation protects homeowners from rising rates and payments, which can lead to defaults and foreclosures.
The home buyer selects the number of years until the first adjustment of his loan. The most common selection is five years, which creates an ARM of 5 years.
Home buyers can also choose from 3 year ARM, 7 year ARM and 10 year ARM.
After the buyer selects an introductory term, the lender offers an introductory interest rate. Smaller ARMs get lower interest rates. Then, the loan is margined and indexed.
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margin and index
Margin is a constant used to calculate future interest rate adjustments. The margin for most conventional ARMs is 2.75 percentage points.
Index is a variable that is used in the same equation. Traditional ARMs use the 1-year US Treasury rate, which is currently near 2.00 percent.
When an ARM adjusts, its new interest rate is the sum of the margin and the index. However, the government limits how much an ARM’s interest rate can change.
The ARM limit is known as the CAP.
Caps keep ARM interest rates within a safe, controlled range. A specific cap prevents rates from going up or down by more than 2 percentage points.
On a 5 year old ARM the caps look like this:
- After five years, the adjustment is limited to ±5 percentage points
- After each year, the adjustment is limited to ±2 percentage points
Nonconforming ARMs, including jumbo and portfolio loans, may use different indexes, margins, and caps. Ask your lender for details.
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ARM type
The standard adjustable-rate mortgage is a traditional mortgage backed by Fannie Mae and Freddie Mac. It accounts for the majority of ARMs issued by mortgage lenders.
Other ARM variants also exist. Let’s review them.
FHA ARM and VA ARM
FHA and VA ARMs are adjustable-rate mortgages offered through the FHA or VA. The FHA and VA ARMs can adjust each year over their 30-year life. They carry government-mandated limits of 1 percentage point per year and five percentage points over the life of the loan.
hybrid arm
Hybrid ARM is another name for traditional mortgage ARM. The term “hybrid” refers to the loan’s adjustment schedule, which causes it to resemble a fixed-rate mortgage for a few years and then an adjustable-rate mortgage later.
Hybrid ARMs are standard ARM programs used by first time buyers. They are rarely called “hybrid ARMs”.
interest only
Interest-only ARMs are adjustable-rate loans that do not require monthly principal payments. Government regulation reduced the availability of interest-only loans between 2008-2012.
Today, they are only available as specialty products from local banks.
payment options
Payment Options The ARMs were adjustable-rate loans that let homeowners choose from four payment options – full payment, partial payment, interest-only payment and minimum payment. Sometimes called the option ARM, the paid-for poor performance option ARM was retired in 2008.
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How do you know if ARM loans are right for you?
Since 2000, ARMs have accounted for about 10% of all conventional mortgages made,
And they’re less common when mortgage rates are low. There are two scenarios, however, when homeowners should always choose an ARM.
Scenario 1: Use an ARM when you’re selling or refinancing within five years
When you know you will sell your home within five years or are confident that you will refinance your mortgage, a 5-year ARM can lower your interest rate and save you money on your home loan.
The typical 5-year ARM sells for 62 basis points (0.62%) below a comparable fixed-rate mortgage, saving $450 per year per $100,000 at today’s rates.
Scenario 2: Use an ARM when you’re comfortable sharing interest rate risk with your lender
ARMs can offer lower starting interest rates than fixed-rate loans. However, the interest rate adjusts after the initial teaser period of the loan.
Let’s say you’re comfortable with changing mortgage interest rates. In that case the ARM may be a wise financial decision.
Scenario 3: If the thought of ARM worries you, don’t use ARM
The ARM can be an effective money-management tool, but not if it comes at the cost of lost sleep. If loan adjustments bother you, don’t use an ARM. There will be no savings for your trouble.
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ARM frequently asked questions from first time home buyers
Here is a list of frequently asked questions about adjustable-rate mortgages from our chats and found in online forums.
What is “toxic ARM”?
Between 2005-2008, some mortgage lenders offered ARMs known as payment option ARMs. Payment Options ARMs let homeowners choose from monthly payment options for the first five years. Many homeowners chose the least expensive option while adding additional principal to the home’s existing loan balance.
When the house began to lose value, a clause in the option’s ARM paperwork triggered a reset. Homeowners’ new payments increased, and a greater number of homes went into foreclosure.
For the damage done to the mortgage ecosystem, payment option ARMs are now known as toxic ARMs.
Is ARM secure?
Adjustable-rate mortgages are safe when used responsibly. Introductory interest rates are lower than fixed-rate mortgages, and interest rate caps prevent rapidly increasing payments.
Are ARMs Better Than Fixed Rate Mortgages?
ARMs are neither better nor worse than fixed-rate mortgages. ARMs may be right for you if you plan to sell or refinance within five years of purchase or if you want to share the risk over the time of your loan.
Are Fixed Rate Mortgages Safer Than ARMs?
Fixed rate mortgages are not as secure as an ARM. The advantage of a fixed rate mortgage is that you know exactly what your mortgage payments will be for the next 30 years. In exchange for that certainty, you’ll pay a higher mortgage rate. Fixed-rate mortgages aren’t just more secure – they’re more fixed.
Can my ARM mortgage rate go up to 20% overnight?
No, your ARM cannot change overnight or go up to 20% due to caps. ARMs can only adjust after the initial term is over and on subsequent anniversaries. And, when ARMs adjust, they may only change by a few percentage points at a time.
Can You Refinance an Adjustable-Rate Mortgage?
Homeowners can refinance an ARM or fixed-rate mortgage at any time. However, ARMs do not adjust higher consistently. Before you refinance your ARM, compare your future adjusted interest rate to today’s mortgage rates. If today’s rates are high, don’t refinance your ARM.
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