Definition of Adjustable Rate Mortgage (ARM)
In case you're not familiar with the term, an adjustable rate mortgage (ARM), also referred to as a variable rate mortgage, refers to a type of mortgage (home loan) that has a fluctuating annual percentage rate (APR).
The amount and direction by which the ARM rate fluctuates are based on a variety of indices (US Treasury Bills, Cost of Funds Index, etc.), with the periodic adjustments occurring at preset intervals (usually once each year following the time the initial APR is guaranteed for).
Variable/Adjustable Rate Mortgage Basics
Since ARM loans shift the interest rate risk from the lender to the borrower, ARM loans typically offer lower interest rates than fixed APR loans. If interest rates rise, the ARM borrower loses money. If interest rates fall, the ARM borrower saves money.
The typical ARM loan has an initial APR that is guaranteed to remain constant for the first 1-15 years of the repayment period while stipulating a maximum APR adjustment that may occur each subsequent adjustment period (usually 12 months, but may be as many as 180 months). For example, an ARM loan may have an initial guaranteed APR of 6% for the first 36 months, after which it could increase by a maximum of .25% per year.
ARM loans usually come with a rate cap, which is the maximum APR that can be charged. So if an ARM loan has a rate cap of 10%, that will be most the lender can charge you during the repayment period. However, be aware that if you are being charged the maximum APR and the rate later falls to below the maximum, the lender will likely try to recover their losses by not lowering your APR (referred to as a carryover).
Of course, as the APR changes on an ARM loan, so do the size of the monthly house payments. As interest rates rise, the monthly payments rise, and visa versa. This can wreak major havoc on even the best of household budgets.
Types of Adjustable Rate Mortgages
Hybrid ARMS: Hybrid ARMs offer a mixture of fixed and adjustable-rate terms, and are usually listed as 3/1, 5/1, 5/5, 7/1, 10/1, or 15/15. The number appearing before the slash refers to the number of years the APR will be fixed, while the number after the slash refers to adjustment interval in years. Therefore the APR on a 5/1 ARM will be fixed for 5 years and may be adjusted once each year for the remainder of the repayment term. The adjustable-rate mortgage payment calculator on this page is based on a Hybrid ARM.
Interest-Only ARMS: Interest-only ARMs allow you to pay only the interest for a specified number of years -- usually for 3 to 10 years. This affords the borrower a low initial monthly payment, but at the expense of a much higher payment once the interest-only term has expired. Keep in mind that the longer the interest-only term, the higher will be the future principal plus interest payment.
Payment-Option ARMS: A payment-option ARM allows the borrower to choose among various payment options each month. In this type of an ARM, you may choose to make a principal interest payment (PI), or an interest-only payment, or a minimum payment. If you choose the latter option, be forewarned that it may lead to negative amortization, which means the minimum payment is less than the interest charged, which in turn will cause the principal (the amount you owe) to increase (balloon).
ARM Warnings
Be sure to be on the lookout for lenders offering teaser rates, or discounted rates. This is where ARM lenders offer an APR that is below the indexed APR just to get you to sign on the dotted line. Later, when the initial fixed term expires, you could experience a shocking payment increase that you may not be able to afford.
A second word of caution has to do with prepayments. Many ARM lenders assess stiff prepayment and conversion penalties if you make any attempt to shift the interest rate risk back on the lender. In other words, if you try to pay off the ARM early or if you try to convert the ARM to a fixed-rate mortgage, you may be assessed stiff prepayment penalties or conversion fees.
While it may be true that ARM borrowers have saved money historically, it's also important to realize the risk you are assuming before entering into an ARM. Lending institutions are much better equipped to assume the interest rate risk than you are. After all, they don't face the prospect of losing their job, and most of their risk is backed up with assets. You, on the other hand, could lose your job or end up upside down in your mortgage (your house is worth less than you owe), so please consider those possibilities before you enter into an adjustable-rate mortgage.
The Bottom Line
If you've spent any time in the financial calculators section of this website, you will know that I'm of the opinion that if you can't afford to pay cash for something, you can't afford it (as in, the opportunity costs of borrowing money can rob you of potential future wealth and happiness). Therefore, it doesn't matter if we're talking fixed, variable, interest-only, adjustable, or any other kind of "borrow from my future happiness to be happier today" type of mortgage, they are all just different ways of transferring your potential future wealth to the CEOs of lending institutions.