Adjustable Rate Mortgage (ARM)

Definition of "Adjustable Rate Mortgage (ARM)"

Brigitte Baroukh real estate agent

Written by

Brigitte Baroukhelite badge icon

Berkshire Hathaway HomeServices Florida Realty

Also called variable or flexible rate mortgage, an adjustable rate mortgage (ARM) is a mortgage where the interest rate is not constant, but changes over time by the mortgage lender.

Adjustable Rate Mortgages (ARM) often have attractive beginning interest rates, called teaser rates, and monthly payments. However, there is the risk that payments will increase.

While Adjustable Rate Mortgage (ARM) contracts in many countries abroad allow rate changes at the lender's discretion, in the U.S. rate changes on Adjustable Rate Mortgages (ARM) are mechanical. They are based on changes in an interest rate index over which the lender has no control.

Reasons for Selecting an Adjustable Rate Mortgage

Borrowers may select an Adjustable Rate Mortgage in preference to a fixed rate mortgage (FRM) for three reasons:

  1. To qualify: they need an Adjustable Rate Mortgage to qualify for the loan they want.To qualify: they need an Adjustable Rate Mortgage to qualify for the loan they want.
  2. To take advantage of low initial rates on Adjustable Rate Mortgages and their own short time horizon: they expect to be out of their house before the initial rate period ends.
  3. To gamble on future interest rates: they expect that they will pay less on the Adjustable Rate Mortgage over the life of the loan and are prepared to take the risk that rising interest rates will cause them to pay more.

How to determine the Interest Rate on an ARM

There are two phases in the life of an Adjustable Rate Mortgage. During the first phase, the interest rate is fixed, just as it is on a Fixed Rate Mortgage (FRM). The difference is that, on an FRM, the rate is fixed for the term of the loan, whereas on an ARM it is fixed for a shorter period. That period can range from one month to 10 years, and, at the end of the initial rate period, the ARM rate is adjusted. The adjustment rule is that the new rate will equal the most recent value of a specified interest rate index, plus a margin.

For example, if the index is 5% when the initial rate period ends, and the margin is 2.75%, the new rate will be 7,75%.

This rule, however, is subject to two conditions. The first condition is that the increase from the previous rate cannot exceed any rate adjustment cap specified in the ARM contract. An adjustment cap, usually 1% or 2% - but ranging in some cases up to 5% - limits the size of any interest rate change. The second condition is that the new rate cannot exceed the contractual maximum rate. Maximum rates are usually five or six percentage points above the initial rate.

During the second phase of an Adjustable Rate Mortgage life, the interest rate is adjusted periodically. This period may or may not be the same as the initial rate period. For example: an ARM with an initial rate period of five years might adjust annually or monthly after the five-year period ends.

Real Estate Tips:

Browse through The OFFICIAL Real Estate Agent Directory and find a real estate agent that will know the best mortgage type for you!

image of a real estate dictionary page

Have a question or comment?

We're here to help.

*** Your email address will remain confidential.
 

 

Popular Mortgage Terms

Loan applications that are withdrawn by borrowers, because they have found a better deal or for other reasons. ...

Acceptance of the borrower's loan application. Approval means that the borrower meets the lender's Qualification Requirements and also its Underwriting Requirements. In some cases, ...

The method of financing used when a borrower contracts to have a house built, as opposed to purchasing a completed house. Construction can be financed in two ways. One way is to use two ...

A Web site of an individual lender offering loans to consumers. Most Internet shoppers want a list of lenders in whom they can have confidence, who will provide them with the information ...

Same as term Lead Generation Site: A mortgage Web site designed to provide leads to lenders. A 'lead' is a packet of information about a consumer in the market for a loan. Lenders pay ...

Limit on the size of payment change on an adjustable rate mortgage. ...

A payment made by a lender to a mortgage broker for delivering an above-par loan. A par loan is one on which the lender charges zero points. Lenders charge points on loans carrying ...

Fixed rate Mortgage is a type of loan that maintains a specified interest rate for the lifetime (or maturity) of the mortgage.According to the Federal National Mortgage Association, ...

All the combinations of interest rate and points that are offered on a particular loan program. On an ARM, rates and points may also vary with the margin and interest rate maximum. ...

Popular Mortgage Questions