All About Adjustable-Rate Mortgages

Adjustable-rate mortgages (ARMs) differ from fixed-rate mortgages in that the interest rate and monthly payment can change over the life of the loan. ARMs also generally have lower introductory interest rates vs. fixed-rate mortgages. Before deciding on an ARM, key factors to consider include how long you plan to own the property, and how frequently your monthly payment may change.

Why choose an adjustable-rate mortgage?
The low initial interest rates offered by ARMs make them attractive during periods when interest rates are high, or when homeowners only plan to stay in their home for a relatively short period. Similarly, homebuyers may find it easier to qualify for an ARM than a traditional loan. However, ARMs are not for everyone. If you plan to stay in your home long-term or are hesitant about having loan payments that shift from year-to-year, then you may prefer the stability of a fixed-rate mortagage.

Components of adjustable-rate mortgages
Adjustable-rate mortgages have three primary components: an index, margin, and calculated interest rate.

  • Index
    The interest rate for an ARM is based on an index that measures the lender's ability to borrow money. While the specific index used may vary depending on the lender, some common indexes include U.S. Treasury Bills and the Federal Housing Finance Board's Contract Mortgage Rate. One thing all indexes have in common, however, is that they cannot be controlled by the lender.
  • Margin
    The margin (also called the "spread") is a percentage added to the index in order to cover the lender's administrative costs and profit. Though the index may rise and fall over time, the margin usually remains constant over the life of the loan.
  • Calculated interest rate
    By adding the index and margin together, you arrive at the calculated interest rate, which is the rate the homeowner pays. It is also the rate to which any future rate adjustments will apply (rather than the "teaser rate," explained below).

Adjustment periods and teaser rates
Because the interest rate for an ARM may change due to economic conditions, a key feature to ask your lender about is the adjustment period--or how often your interest rate may change. Many ARMS have one-year adjustment periods, which means the interest rate and monthly payment is recalculated (based on the index) every year. Depending on the lender, longer adjustment periods are also available.

An ARM can also have an initial adjustment period based on a "teaser rate," which is an artificially low introductory interest rate offered by a lender to attract homebuyers. Usually, teaser rates are good for 6 months or a year, at which point the loan reverts back to the calculated interest rate. Remember, too, that most lender will not use the teaser rate to qualify you for the loan, but instead use a 7.5% interest rate (or calculated interest rate if it is lower).

Mary Bremer
Mary Bremer
Team Leader