What is an Adjustable Rate Mortgage?

Adjustable Rate Mortgage (ARM) Definition

An Adjustable Rate Mortgage (ARM) is a mortgage loan with an interest rate that will change over the life of the loan based upon changes in the current interest rates, often, the prime interest rate. Payments made by the borrower will change periodically with the changing interest rate. This type of mortgage is different than a fixed rate mortgage, where the interest rate will remain the same over the life of the loan.

Advantages of an ARM

An Adjustable Rate Mortgage usually begins with a lower interest rate than a fixed rate mortgage. The lower interest rate will result in lower monthly payments which may permit the borrower to take out a larger mortgage. Lowering market interest rates will make the ARM advantageous to the borrower. An adjustable rate mortgage can also be used in a situation where interest rates fluctuate greatly, and fixed rate mortgages are more difficult to obtain.

Disadvantages of an ARM

Conversely, if interest rates rise, the borrower’s monthly payment will also rise. Because the adjustable rate mortgage can rise or fall depending on the current prime interest rate, if the rate increases 2%, your mortgage rate will then increase from a 5% mortgage to a 7% mortgage. Due to the higher interest rate, the monthly payment for principal and interest will also increase.

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Examples

You can obtain an adjustable rate mortgage of $200,000 with an initial interest rate of 5% and a 30 year amortization period. At the same time, the best fixed rate mortgage you can obtain for the same loan is 6%. What is the effect on the monthly payment?

$200,000 ARM at 5% interest = $1,067.38initial monthly payment
$200,000 fixed rate mortgage at 6% interest = $1,189.65 initial monthly payment

If the interest rate on an adjustable rate mortgage increases to 7%, here is the difference in the monthly payment:

$200,000 ARM at 5% interest, increased to 7% = $ 1,317.21 revised monthly payment
$200,000 fixed rate mortgage at 6% interest (stays at 6%) = $1,189.65 revised monthly payment

Rate and Frequency Caps

The mortgage and regulation will limit amount the interest rate or the monthly payment may be changed as well as the number of times the interest rate may change. This can apply to each adjustment period or to the total term of the loan. In addition, there may be limits on the cumulative change in interest rates over the the loan term, sometimes called a life cap.

For instance, the mortgage may provide that the interest rate cannot be increased more than every 6 months, or annually. It may provide that you cannot increase more than 1% per rate change, or more than 2% annually. It may also have a provision that the mortgage interest rate may not increase more than 6% over the life of the loan.

The Adjustable Rate Mortgage has become popular, largely due to the lower monthly payment at the beginning of the loan. Borrowers will often risk a higher payment later in the repayment period, counting on higher income later down the road. Borrowers in a high interest market may also speculate that interest rates will eventually fall, thereby lowering their monthly payment. The mortgage professionals at First Foundation have a variety of mortgage products available to best suit your needs and goals.

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Last updated Jul 17, 2014