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Adjustable Rate Mortgage

An adjustable rate mortgage (ARM) is a mortgage where your interest rate and monthly payment vary over time. The opposite of an adjustable rate mortgage is a fixed rate mortgage. Adjustable rate mortgages are characterized by their index and limitations on charges (caps). In many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages.

Adjustable Rate Mortgages (ARMs) are a good choice when:

Features of an ARM

An ARM has features that distinguish it from other ARMs. Some of the primary features include:

Index

An adjustable rate mortgage's interest rate goes up and down according to a nationally published index. Different adjustable rate mortgages are based on different indexes, and the index is specified before settlement of the loan.

Example indexes include:

Margin

The margin is the lender's profit on the loan. Your interest rate is the sum of the index plus the margin:

interest rate = index + margin

For example, if the index is 7.5 percent and the margin is 2.5 percent, the interest rate is 10.0 percent (7.5 percent plus 2.5 percent). Your lender sets the margin before settlement of your loan, and the margin does not change for the life of the loan.

Adjustment Frequency

The adjustment frequency is how often the interest rate changes (gets reset). The day the interest rate changes is sometimes called the reset date. Different adjustable rate mortgages have different adjustment frequencies. Usually the adjustment frequency is once a year, but it could be as often as once a month or as long as five years. The less often your loan adjusts, the less financial risk you are accepting so the lender usually expects you to pay a higher initial interest rate (see below) or higher margin.

Initial Interest Rate

The initial interest rate is the interest rate you pay until the first reset date. The initial interest rate determines your initial monthly payment, which the lender may use to qualify you for a loan. Often the initial interest rate is less than the sum of the current index plus margin so your interest rate and monthly payment will probably go up on the first reset date.

Interest Rate Caps

The interest rate caps limit the amount that your interest rate and monthly payment can increase. The most common caps are:

Initial Adjustment Cap

An initial adjustment cap limits how much your interest rate can change at the first adjustment period. So if your adjustable rate mortgage has a one percent initial adjustment cap, your interest rate can only increase or decrease by a maximum of one percent at the first adjustment period.

Periodic Adjustment Cap

A periodic adjustment cap limits how much your interest rate can change from one adjustment period to the next. Usually a six month adjustable rate mortgage will have a one percent periodic adjustment cap while a one year adjustable rate mortgage will have a two percent periodic adjustment cap. So if your loan has a two percent periodic adjustment cap, your interest rate can only increase or decrease by a maximum of two percent per adjustment period.

Lifetime Cap

A lifetime cap sets the maximum and minimum interest rate that you can be charged for the life of the loan. Lifetime caps vary by lender, but most adjustable rate loans have caps of five or six percent above the initial interest rate. So if your loan has a six percent lifetime cap, your interest rate can only increase or decrease by a maximum of six percent for the life of the loan.

Initial adjustment caps, periodic adjustment caps, and lifetime caps make up an adjustable rate mortgage's cap structure, and are usually represented as three numbers, such as 1/2/6, which means that the initial adjustment cap is one percent, the periodic cap is two percent, and the lifetime cap is six percent.

Convertibility

Convertibility specifies if you can convert it to a fixed rate. If an adjustable rate mortgage is convertible, you can convert it to a fixed rate mortgage without refinancing. The terms of convertibility vary among lenders.