What is an Adjustable Rate Mortgage (ARM)?

Published February 10, 2019

Key Takeaways

  • Well-informed homebuyer can realize significant savings in their monthly mortgage payments.
  • There are several reasons why an adjustable-rate mortgage might be right for you.
  • Understanding the caps on your ARM’s interest rate will help you plan what your monthly payments. 

You’ve decided to become a homeowner — congratulations! Maybe you’ve spent time over the weekends visiting open houses and have an eye on a particular neighborhood. It’s an exciting time, but before you start picking out new curtains you will need to know how much you can afford to spend on a home, work with a mortgage loan expert to get prequalified for a mortgage and determine the type of mortgage interest rate that works best for you.

Types of mortgage interest rates

There’s a lot of information to digest. However, a well-informed homebuyer can realize significant savings in their monthly mortgage payments or afford a lot more home for their money.

While the Credit Union of Texas (CUTX) has a wide variety of competitively priced mortgage options available, there are basically two types of mortgage interest rates to choose from: a fixed-rate and an adjustable-rate mortgage (ARM). There are important differences, and each has its advantages; understanding them will make working with one of our mortgage loan experts easier when it’s time to choose the right mortgage for your situation.

The interest rate for fixed-rate mortgages remains the same for the duration of the loan, which makes your monthly principal and interest payments consistent no matter what happens to interest rates.

Why would you choose an ARM?

There are several reasons why an adjustable-rate mortgage might be right for you. It’s a good idea to compare all of your options before deciding upon the type of mortgage interest rate.

We detail adjustable-rate mortgages in this article, but here are the basic features:

  • Lenders charge a lower initial interest rate for an ARM than they do for a fixed-rate mortgage. This lower rate is good for an initial fixed period and will not change during that time. This results in lower monthly payments during the initial fixed-rate period.
  • An ARM mortgage might be less expensive than a fixed-rate mortgage over the long term should interest rates remain steady or move lower during the term of the loan.
  • There is the possibility that interest rates will increase over the term of your loan, which will cause the interest rate of your ARM to increase after the initial fixed period. However, adjustment caps associated with your ARM ensure your interest rates cannot increase more than the caps allow, which may keep your monthly payments affordable even should interest rates increase.

An ARM may be the right choice if any of these situations apply to you:

  • You may want to use the savings you will realize during the initial fixed period to make improvements to your home.
  • You may have reason to believe that over time your income will increase enough to cover higher mortgage payments should interest rates increase.
  • You might plan to sell the home, or refinance the mortgage loan, before your ARM’s interest rate is scheduled to change.
  • You might plan to make additional payments to lower the principle or pay the loan off early.

Make sure you are aware of any penalties associated with refinancing or paying off your mortgage loan early.

Adjustable-rate mortgage facts

How are interest rates calculated?

Mortgage interest rates are affected by many factors. The first involves your specific situation and include your credit score, the location of the home and its price, the down payment you’re willing to make, and term of the loan. The type of loan you choose is a factor, and include conventional, FHA or special program loans. Your interest rate is also determined by the type of mortgage interest rate you choose, a fixed-rate or an adjustable-rate mortgage.

Fixed-rate and adjustable-rate periods of an ARM

Adjustable-rate mortgage loan products feature an initial fixed-rate and adjustable-rate periods. The most common fixed-rate periods are 3, 5, 7 or 10 years. After the initial fixed-rate period, periodical adjustment periods vary between every 1, 3 or 5 years. This means that your interest rate may change at the end of each adjustment period. You will be notified in advance of any change to your ARM interest rate.

How do ARM interest rates change?

After the initial fixed-rate period, the rate may change periodically to reflect current market conditions. A change to the interest rate is related to a specific index, which is documented in your mortgage, and can include:

  • The Prime Rate— the rate at which banks loan money to their most creditworthy customers.
  • LIBOR— the rate that banks lend to one another for short-term loans.
  • U.S. Treasury Bill (T-Bill) — The rate of a short-term debt backed by the Treasury Department.

Your ARM interest rate could increase or decrease based on the performance of these indexes.

More about rate caps

An adjustable-rate mortgage will typically contain rate adjustment caps. These caps put a limit on how much your interest rate can increase.

  • The Initial Adjustment Cap limits any rate increase upon the expiration of the fixed-rate period. It’s common for this rate cap to be between 2 and 5 percent.
  • Subsequent Adjustment Caps limit the amount your interest rate can increase at each adjustment period. It’s common for this rate cap to be about 2 percent.
  • The Lifetime Adjustment Cap limits the amount your interest rate can increase in total over the term of the loan. It’s common for the lifetime adjustment rate cap to be about 5 percent.

Understanding the caps on your ARM’s interest rate will help you plan what your monthly payments could be after the initial fixed-rate period expires and will allow you to compare payments to other mortgage options. Your mortgage loan expert can help you calculate these monthly payments, and this information is included in the Truth-in-Lending document, which you will receive at least three business days after you apply for a mortgage loan.

Is an ARM right for you?

Whether you’re just starting to look for a home, or you have your heart set on that rambler with a white picket fence, you’re armed with the information you need about mortgage interest rates to make the right decision for your situation. Now you can concentrate on picking out curtains.

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