How Do ARMs Work for Mortgages?

What is an ARM?

ARM stands for Adjustable Rate Mortgage. Unlike the traditional 30-year fixed mortgage, the interest rate on an ARM can move up or down, depending upon current interest rates and the terms of the mortgage.

An interest rate is the percentage which interest is charged on a loan in order to compensate the lender for the use of their money for a period of time. Although the Federal Reserve (usually noted as the FED) sets short-term interest rates, long-term interest rates are determined by the financial markets.

A mortgage is a long term loan traditionally collateralized by real estate. A borrower is taking funds and agreeing to pay them back at a specific time. This agreement is secured by the lender's right to take, without additional compensation, the real estate involved in the event of non-payment. Traditionally mortgages are for long periods of time, with the most common period of 30 years and the second most common period of 15 years.

Because a mortgage is a long term loan, it is very possible that interest rates will rise and fall over the life of the mortgage. For a lender, the maximum possible profit is achieved when getting the highest possible interest rate from a borrower. However, that rate my be significantly lower than what a lender could get from a borrower at a later date. In order to lessen the risk of having funds invested (lent) at a lower rate than the current market rate in the future, the mortgage interest rate can be adjustable instead of fixed. To make this equitable to the borrower, such a mortgage often comes with a lower initial rate of interest.

Some ARMs have a length of time during which the rate will not adjust, regardless of market conditions. These are often described by that length. For example, a 5-Year ARM or a 5-Year Fixed mortgage describe an ARM which has a provision that says the interest rate will not adjust during the first five years. Generally, the longer the fixed period, the less the rate reduction from a fully fixed mortgage. So, a 3-Year ARM would generally have a lower starting interest rate than a 7-Year ARM.

An Adjustable Rate Mortgage has terms that specify when and how the interest rate will adjust. These terms will also specify a particular way of determining the current interest rate. Most commonly, this is done by selecting an interest rate index. The actual interest rate to be charged is often the value of the index plus a certain amount. For example the index plus three percent.

There may also be terms limiting by how much an interest rate can adjust at one time. For example, a mortgage may have terms that state the interest rate cannot increase or decrease at a rate of more than 2% per year. In this case, if the calculated interest rate is too high or too low, the interest rate will be set at the maximum movement. In our example, the new rate would be the old rate + 2%.

The lender will recalculate the scheduled mortgage payments using the current remaining balance of the mortgage and the new interest rate in such a way that the loan is still paid off at the same time as originally agreed upon. So, if a 30 Year ARM has been in effect for 8 years, then the lender will calculate a payment based on the balance with the new interest rate over a period of 22 years (the time remaining on the mortgage).