What Is an ARM Home Loan?

ARM loan rates reset once a year, based on a rate index.

Adjustable-rate mortgages--ARM loans--are one option for financing the purchase of a home. ARMs have some advantages and disadvantages over the conventional 30-year fixed-rate mortgage. ARM loans are more complicated than fixed-rate mortgages, so a homeowner should understand the possible outcomes before selecting an ARM to finance a home.

Identification

ARMs are just what their name says: They are mortgages whose rates are periodically adjusted to be in line with current interest rates. The typical ARM interest rate is adjusted once a year, on the anniversary of the mortgage. The result of the rate adjustment is a changing mortgage payment for the homeowner.

Function

An ARM loan's rate is based on a short-term interest rate benchmark. Common benchmark rates are the U.S. Treasury one-year rate and the London Interbank Offered Rate (LIBOR). The adjustable mortgage's rate will be set at the benchmark rate, plus a margin. The margin for ARMs is usually two to three percentage points above the benchmark. A new payment is then calculated using the new rate. The new payment will be in effect for one year, when the rate will be reset again.

Effects

ARM rates are based on short-term interest rates, so the initial rate of an ARM will usually be lower than the 30-year fixed mortgage rate, which is based on long-term rates. For example, in the third week of June 2010, the average rate for a new 30-year fixed-rate mortgage was 4.69 percent; the average one-year ARM rate was 3.77 percent. The difference is the 30-year mortgage has a rate locked in for the life of the mortgage, and the ARM interest rate and monthly payment can go up or down every year.

Features

ARM loans include annual and lifetime caps on how much the rate can increase. Typical rate caps are 2 percent in a year and 6 percent for the life of the mortgage. ARMs are also available as hybrid mortgages, where the initial rate is fixed for a period of three, five or seven years. These mortgages are designated as 3/1, 5/1 and 7/1 ARMs. After the fixed-rate period, the mortgage rate adjusts every year, just like a regular ARM.

Considerations

Home buyers considering an ARM must understand the worst-case scenario concerning interest rates. Do not take an ARM based on the low initial payment. An ARM may make sense if you believe interest rates will stay low for at least several years so that you can reap the benefits of the lower payments. An ARM borrower must be in a financial position to make higher payments if rates rise or have money to buy down the principal amount to keep the payments down.

References

• Federal Reserve Board: Consumer Handbook on Adjustable-Rate Mortgages
• Reuters: 30-Year Mortgage Rate Drops to 39-Year Low