As the term suggests, the adjustable-rate mortgages (also known as a variable-rate loans) are subject to interest rate adjustment. Consequently your loan payment can go up when interest rates increase, however, if interest rates go down, the monthly payment will decrease with adjustable-rate mortgages.
Now you might be thinking, “why would anyone get involved with a loan with a variable interest rate? The reason for many home buyers is the lower interest rate for the 1st year. A lower interest rate means prospective home buyers can borrow more money from the bank or mortgage broker and thus purchase a more expensive home.
Another reason home buyers choose ARMs is because they believe interest rates will be going down, and consequently, their payment will decrease. In 1982 mortgage rates were 18%. So a prospective homeowner who took out an adjustable-rate mortgage in 1982 would have seen their monthly loan payment decrease as the years rolled along.
Home buyers who believe they will remain in the home for a few years are attracted to adjustable-rate mortgages because of the lower initial interest rate and the belief that even if the interest rates do increase, they will have moved on to another house or will be transferred by their employer.
Sadly, many sub-prime mortgages were structured with an adjustable-rate mortgage and millions of homeowners were not able to keep up with the increasing interest rate adjustments.
Adjustable-rate mortgages can be a good choice if you absolutely, positively know you’re going to live in the home for only a few years. Adjustable-rate mortgages enable prospective home buyers to purchase homes during times of high interest rates, but with interest rates at an all time low, gambling on a slightly lower interest rate doesn’t make sense.
Types of adjustable-rate mortgage loans
There are numerous varieties of adjustable-rate mortgages. The following chart illustrates the most popular adjustable-rate mortgages.
The one-year ARM provides the lowest interest rate because the interest rate is "fixed" for only 12 months.
The 10-year ARM usually has the highest interest rate. The interest rate increases as the fixed-rate part of the ARM increases.
Some lenders offer interest only option on their adjustable-rate mortgages and will amortize the loan over a 40 term.
1 year adjustable-rate
Lowest Interest Rate
Every 12 months
3/1 arm mortgage
Interest rate is higher than a 1/1 ARM
fixed-rate for 3 years (36 months), then subject to adjustment
5/1 arm mortgage
Interest rate is higher than a 3/1 ARM
fixed-rate for 5 years (60 months), then subject to adjustment
7/1 arm mortgage
Interest rate is higher than a 5/1 ARM
fixed-rate for 7 years (84 months), then subject to adjustment
10/1 arm mortgage
Interest rate is higher than a 7/1 ARM
fixed-rate for 10 years (120 months), then subject to adjustment
ARM vs. fixed-rate mortgage comparison
($200,000 & 30-year Amortization)
1 year adjustable-rate
Adjustable-rate mortgage qualifying rate
Lenders qualify borrowers on the interest rate plus 2% for adjustable one, 3/1 and 5/1 rate and the note rate for 7/1 and 10/1 arms.
How much can an adjustable-rate mortgage increase?
Just before the last payment on the ARM, the lender will calculate the new interest rate based on one of the "indexes", such as the Cost of Funds Index (COFI), the London Interbank Offered Rate (Libor), or the cost of one-year Treasury bills.
The lender will then add the "margin" to the index. But, what if interest rates take a turn and increase significantly? The arms usually come with a safety valve called caps. There is a periodic cap and a lifetime cap. The caps vary between the arm programs (i.e. FHA versus conventional), but the usual cap is 2% for the adjustment period and a lifetime cap of 5% over the starting interest rate.
The lender compares the indexed rate with the capped rate and gives you the lower of the two calculated rates.
Frequently Asked Questions About ARMs
Can an adjustable-rate mortgage go down?
Yes. Assuming the adjustable-rate mortgage is not in it's fixed period (i.e. 3/1, 5/1, 7/1, etc.), and is subject to adjustment, the interest rate can go down if the underlying index decreases. During the 1980's when the interest rates were in the double digits, many homebuyers took out adjustable-rate mortgages to finance their home. As the interest rates decreased, the adjustable-rate on their mortgage also decreased.
Can you prepay an adjustable-rate mortgage?
Probably. Read the loan papers you signed at settlement to determine whether there is a prepayment penalty for an early payoff. Typically, if there is a prepayment penalty, it is for the first 3 to 5 years. For home mortgages issued after January 10, 2014, mortgage lenders are only permitted to charge prepayment penalties for the first three years of the loan; with a maximum penalty of 2%.
Do adjustable-rate mortgages have prepayment penalties?
Prepayment penalties were often a condition of sub-prime mortgages. Since the passage of the Dodd–Frank Wall Street Reform, and Consumer Protection Act, prepayment penalties have largely gone away. Fortunately, the required loan estimate that must be provided to the borrower(s), states whether the proposed mortgage carries a pre-payment penalty.
Does FHA offer adjustable-rate mortgages?
The Federal Housing Administration (FHA), permits adjustable-rate mortgages. Prepayment penalties are prohibited with FHA adjustable-rate mortgages.
The interest rate cap structure protects against significant interest rate fluctuations. Annual caps and life-of-loan caps are the two forms of caps.
The annual cap restricts the amount your interest rate may fluctuate in a given year, while the life-of-loan cap governs the highest (and lowest) interest rate you can pay throughout the life of your loan.
The FHA provides a traditional 1-year ARM as well as four "hybrid" ARMs. The interest rate for hybrid ARMs is fixed for the first three, five, seven, or 10 years. After the first term, the interest rate will be adjusted yearly. The following are the different interest rate cap arrangements for various ARM products:
After the first fixed interest rate period, 1- and 3-year ARMs may increase by one percentage point yearly, and five percentage points throughout the life of the loan.
Yearly increases of one percentage point and five percentage points over the life of the loan, or annual increases of two percentage points and six percentage points over the life of the loan, are possible with 5-year ARMs.
After the initial fixed interest rate period, 7- and 10-year ARMs may only increase by two percentage points each year and six percentage points throughout the loan's life.
» LEARN MORE: U.S. Department of Housing and Urban Development
How high can an adjustable-rate mortgage go?
Most adjustable-rate mortgages have a "cap". A cap is an interest rate limit. The cap rate is typically 5% over the start rate. For example, if the start rate is 4% and the cap rate is 5%, then the maximum interest could go as high as 9%. Ouch!
How often do adjustable-rate mortgages change?
The interest rate change depends on the type of arm. One-year arms change every 12 months. Three-year arms are fixed for 36 months. After 36 payments, the interest rate is subject to change every 12 months thereafter. Five, seven, and ten-year arms are subject to annual changes after the initial term.
Should I get a fixed or adjustable-rate mortgage?
Adjustable-rate mortgages can save you a lot of money if you will be paying off the mortgage before the rate changes.
For example, if you know that you will be transferred during the "fixed" rate period, an adjustable-rate mortgage can save you money.
Do you believe that the interest rates will be going lower? If so, then an adjustable-rate mortgage would be your choice. Ask a lender to calculate the (highest) adjustable-rate mortgage payment, year over year and compare the payment to the fixed-rate mortgage.
What are adjustable-rate mortgage caps?
The majority of adjustable-rate mortgages include rate limits. This implies that during the rate change, the interest rate is "limited."
For example, FHA adjustable-rate mortgages may rise by a maximum of 1% with one and three-year arms, and the maximum interest rate throughout the life of the mortgage is limited to 5% above the starting interest rate.
What is the difference between a fixed-rate and an adjustable-rate mortgage?
The fixed-rate mortgage will guarantee you the same principal and interest payment over the life of the mortgage. If you take out a thirty-year mortgage, the 1st payment (principal and interest) will be the same as the 360th payment.