What Is An Adjustable Rate Mortgage?

An adjustable-rate mortgage is also referred to as an (ARM). Maybe you have herd that term before but didn’t know what the acronym meant. This type of mortgage can be really tricky if you don’t know what exactly you are signing up for.

For the rest of this post, I’ll be referring to the adjustable rate mortgage as an ARM. So you ask what is an ARM exactly? It can be a monster (lol).

Different ARMs

The function of an ARM is that the interest rate adjusts periodically. How often do you say the interest rate adjusts? The most common are the fully amortizing loans. Here are some that you will most likely see for a single-family residence:

ARM Type	Months Fixed
10/6 ARM	Fixed for 120 months (10 yrs.), then interest rate adjusts every 6 months.
7/6 ARM	Fixed for 84 months (7yrs.), then the interest rate adjusts every 6 months.
5/6 ARM	Fixed for 60 months (5 yrs.), then interest rate adjusts 6 months.
3/6 ARM	Fixed for 36 months (3yrs.), then the interest rate adjusts every 6 months.

Fully amortizing means that the loan will be paid off when you make your last payment. If you don’t have a fully amortizing loan, then you need to watch out for a balloon payment that will be due at the end of your loan terms. Another piece of wording that you have to look at is the interest rate cap. This tells you what the highest interest rate that is allowed by your loan. Your interest rate will not be adjusted above this rate.

You could also have an ARM that adjusts every year instead of every 6 months. These types of loans keep changing all the time just like life changes! An ARM will include your principal and interest payment. This type of loan is more enticing to get because of the attractive interest rate you will start off with. Remember that this interest rate is only fixed for a certain period of time and will adjust according to the SOFR. SOFR stands for Secured Overnight Financing Rate.

How The ARMs Interest Rate Is Calculated

The Alternative Reference Rates Committee (ARRC) is a group of private market participants convened by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New Yor (NY Fed) to support a successful transition from U.S. Dollar (USD) LIBOR to an ARR. The ARRC recommended the Secured Overnight Financing Rate (SOFR) as a replacement index for USD LIBOR-indexed contracts.

The SOFR is an overnight interest rate based on U.S. dollar Treasury repurchase agreements. The ARRC recommended SOFR because it is:

Based on observable market transactions from a robust and well-defined market that was able to weather the global financial crisis
Produced in a transparent, direct manner
Produced by the NY Fed and meets international benchmark standards

Other ARM Options

Interest-only arms. This means that your monthly payment will be interest only for either 3yrs, 5yrs, 7yrs, 10 yrs. The difference between this interest-only arm and a fully amortizing arm is that when the interest-only payment is up, you will have a principal and interest payment. This could be a payment shock for you because your payment could be double or triple what you are currently making. Also, a balloon payment could be due at the end of the loan. This means you will have to come up with a lump sum payment to finish paying off your mortgage loan.

There are also payment options that are negative amortizing payments, which means you are making less than the interest only for a payment, and the rest of the interest will be put onto your mortgage balance that you originally owed. Usually, you will have 3 payment options. Less than interest only, interest only, and principal and interest payment.

Questions To Ask Yourself

A few things you should think about before you consider an ARM:

Are you planning on moving in the next 3-7 years?
What is the highest that the interest rate can increase?
Is it fully amortizing or does it have a balloon payment at the end of the loan?
What payment options do I have?
What is the main reason I want the arm and not a fixed-rate mortgage?

Food for thought: A lot of people refinance every 3-5 years. What happens if your house does not appraise for what it is worth when the ARM is going to adjust and you find out the new payment you cannot afford? You are in for a surprise!

Finished Reading:

Antonio Vivaldi and the Baroque Tradition. My children and I are learning about classical musicians. This is a great book about Antonio and his life in a short sweet version.

Make sure you always look for the used books first!

Check out my new E-book!

Have you ever had an ARM? What was your stipulations?