What is an Adjustable Rate Mortgage (ARM) Loan?

An adjustable-rate mortgage loan, or ARM loan, is a type of mortgage financing that allows the lender to periodically make interest rate adjustments, with consequent payment recalculation. The adjustments are according to an independent market index, such as U.S. Treasury Bill yields or the Federal Reserve’s Cost of Funds Index (COFI).

Adjustments are normally made once each period, at the anniversary of the loan. For example, a 2-year ARM adjusts its interest rates every two years. But there are exceptions, such ARM loans based on the Prime rate, which are adjusted sporadically by major banks, according to movements of the Prime Rate.

Don’t worry, though. The mortgage lender will not have free reign with the adjustments.

Today’s ARM loan borrowers actually have several protections built into the residential ARM loan program. However, that has not always been the case. In fact, the ARM loan as we know it today is a fairly recent introduction into the mortgage loan market.

Advantages of ARM Loans

ARM loans have ridden a roller-coaster ride of popularity. Most residential loans in the past have been fixed-rate loans with short terms. Before the Great Depression of 1920s and 30s, many of these loans were balloon programs, often with high rates.

This was necessary because the mechanism that ARM loan adjustments depend on, a reliable index, had not been widely available.

The residential ARM loan was first introduced into the national market as the Variable Rate loan. This term still remains in use with credit cards and installment loans, but it has been replaced in the mortgage industry with the more specific and catchy “ARM” label.

When the variable rate mortgage loan first appeared, it was overly restrictive on the lender. So much so that many of them lost money on it. That was good news for borrowers in the short term; but it was bad news in the long term, as lenders and investors threatened to abandon these programs. In the past three decades, the variable rate mortgage was renamed and further redeveloped, as well as diversified, into today’s ARM loan.

Many home buyers still have a natural aversion to ARM loans. Older homeowners who remember the 19% interest rate of the 1970s, are especially leery of the inherent risks of ARM programs. However, ARM loans do have their advantages, which make them ideal for people who can see the home or property purchase as a financial investment.

In fact, ARM loans are the programs of choice for experienced real estate investors.

If you are a homebuyer planning on keeping the home for three years or less, you will often save money by selecting an ARM loan, instead of a fixed-rate loan. Even if you decide to stay past the third year, many ARMs have a conversion option and some lenders provide no-lender-cost refinances.

With the development of 3/1, 5/1 and 7/1 ARMs, which will be discussed in more detail below, ARM programs now offer an even greater opportunity for homebuyers planning a stay of only seven years or less with any one property.

When compared side-by-side, the typical borrower will still save more money with the 1-Year ARM (compared with the fixed-rate) for the first three years. After the third year, depending on how the market reacts, the fixed-rate or balloon loans are generally better.

The reason for the ARM loan’s advantage is that even with any wild increases in the market’s current interest rates, the rate increase caps—or limits—means that monthly payments normally remain lower with the ARM loan for at least two years.

Secondly, ARM loans are the program of choice during periods of high interest rates. History has shown that interest rate fluctuations are normal and tend to be cyclical. During times of comparatively higher rates, borrowers can elect to go with an ARM loan that has a much lower interest rate than the regular 30-year fixed-rate. When the market finally improves to lower rates, the borrower can refinance his or her loan.

Even if you plan to keep your newly found property forever, you should consider using the lower teaser rate of the ARM loan if you find yourself searching for a mortgage loan during a period of relatively higher interest rates. Once interest rates have decreased, you can then refinance the mortgage loan to a lower rate—preferably a fixed-rate program. Many times, your current lender will give you a free refinance, just so they can keep you as a borrower.

Disadvantages of ARMs

The primary disadvantage of the ARM loan is obviously the adjusting interest rate. The caps provide some degree of protection; however, any rate and payment adjustment still hurts.

Also, if the ARM starts with a teaser rate, then the new adjusted rate is bound to be higher—even if the market rate does not increase. Many borrowers will look at the first periods of the ARM—when the teaser discount is still in effect—to be the ARM loan’s honeymoon. Eventually, however, reality must beckon.

A second, albeit minor, disadvantage of the ARM loan is that the mortgage insurance, if any, will be slightly higher than the fixed-rate loan. The mortgage insurance premiums for ARM loans will normally be 10%-20% higher than the mortgage insurance for comparable fixed-rate programs.

The reason for this is because ARM loans do tend to carry more risk for the borrower. Remember that ARM loans allow the borrower to share more of the loan’s risk with the lender. The mortgage insurance is merely a reflection of that increased borrower risk, which is borne out by higher default levels of ARM loans.

Nevertheless, ARM programs have their moments. The key for the home buyer is to use short-term ARM loans for short-term purposes.

ARM Loan Details

An adjustable-rate mortgage (ARM) allows the lender to change the interest rate—at periodic intervals—without altering other conditions of the loan agreement. When the interest rate is adjusted, the monthly principal & interest (P&I) payment is also readjusted.

By so doing, the ARM loan allows the borrower to share more of the loan’s risk. This lowers the lender’s relative risk exposure, so the interest rate on ARMs is usually much lower than those of comparable fixed-rate loans. Several distinct features are found in ARM loans:

• Periods
• Index & Margin
• Caps
• Negative Amortization
• Teaser Rates & Start Rates
• Conversion Option

For more information, see also the following entries:

• :Amortization:
• :Balloon Loan:
• :Cap:
• :Conversion Option:
• :Cost of Funds Index:
• :Fixed-Rate Loan:
• :Index:
• :Interest:
• :Margin:
• :Mortgage Insurance:
• :Mortgage Insurance Premium:
• :Mortgage Loan:
• :Negative Amortization:
• eriod:
• rime Rate:
• rincipal:
• rincipal & Interest:
• rivate Mortgage Insurance:
• &I:
• :Real Estate:
• :Refinance:
• :Residential Property:
• :Start Rate:
• :Teaser Rate:
• :Treasury Bill:
• :Variable Rate Mortgage:
• :Yield: