Adjustable rate mortgage explanation & interest rates

Animate interest rate As the term suggests, an adjustable interest rate mortgage (also known as a variable rate loan) is subject to interest rate adjustment. Consequently your loan payment can go up when interest rates increase, however, if interest rates go down, the monthly payment will decrease with adjustable rate mortgages.

The letters “ARM” are often used instead of Adjustable Rate Mortgage

Here’s an example, let’s say you borrowed $100,000 from the bank to buy a house and the bank offered you an adjustable rate mortgage. The interest rate on the loan during the first year is 5%.

Loan Amount Interest Rate Term Monthly Payment
$100,000 5% 30 Years $ 536.83

Now let’s say the interest rate goes down after one year and your interest rate “adjusts” downward to 4%. Now look at your monthly payment:

Loan Amount Interest Rate Term Monthly Payment
$100,000 4% 30 Years $ 477.42

YIPPI! But then again, if the interest rate increases one percent to 6%, here’s your new monthly loan payment:

Loan Amount Interest Rate Term Monthly Payment
$100,000 6% 30 Years $ 599.55

Confused emoticonNow you might be thinking, “why would anyone get involved with a loan with a variable interest rate? The reason for many home buyers is the lower interest rate for the 1st year. A lower interest rate means prospective home buyers can borrow more money from the bank or mortgage broker and thus purchase a more expensive home.

Another reason home buyers choose ARM’s is because they believe interest rates will be going down, and consequently, their payment will decrease. In 1982 mortgage rates were 18%. So a prospective homeowner who took out an adjustable rate mortgage in 1982 would have seen their monthly loan payment decrease as the years rolled along.

Home buyers who believe they will remain in the home for a few years are attracted to adjustable rate mortgages because of the lower initial interest rate and the belief that even if the interest rates do increase, they will have moved on to another house or will be transferred by their employer.

Sadly, many sub-prime mortgages were structured with an adjustable rate mortgage and millions of homeowners were not able to keep up with the increasing interest rate adjustments.

Adjustable rate mortgages can be a good choice if you absolutely, positively know you’re going to live in the home for only a few years. Adjustable rate mortgages enable prospective home buyers to purchase homes during times of high interest rates, but with interest rates at an all time low, gambling on a slightly lower interest rate doesn’t make sense.

What is a hybrid arm loan?

A hybrid arm combines a fixed rate mortgage with an adjustable rate loan. You may see lenders advertising a 1/1, 3/1, 5/1, 7/1 or 10/1 year ARM. With a 1/1 ARM, the interest rate is subject to adjustment every 12 months. With a 3/1 ARM, the interest rate is “fixed” for the first three years, actually, for the first 36 months; the interest rate is then subject to annual adjustments. The 5/1 ARM is the same as the 3/1 adjustable rate mortgage, except, the interest rate is “fixed” for the first 5 years (60 months). The interest rate is subject to an annual adjustment every year thereafter.

ARM Types Interest Rate Adjustment
1 year adjustable rate Lowest Interest Rate Every 12 months
3/1 arm mortgage Interest rate is higher than a 1/1 ARM Fixed rate for 3 years (36 months), then subject to adjustment
5/1 arm mortgage Interest rate is higher than a 3/1 ARM Fixed rate for 5 years (60 months), then subject to adjustment
7/1 arm mortgage Interest rate is higher than a 5/1 ARM Fixed rate for 7 years (84 months), then subject to adjustment
10/1 arm mortgage Interest rate is higher than a 7/1 ARM Fixed rate for 10 years (120 months), then subject to adjustment

About Adjustable Rate Loans

► Can an adjustable rate mortgage go down?

Yes. Assuming the adjustable rate mortgage is not in it's fixed period (i.e. 3/1, 5/1, 7/1, etc.), and is subject to adjustment, the interest rate can go down if the underlying index decreases. During the 1980's when the interest rates where in the double digits, many homebuyers took out adjustable rate mortgages to finance their home. As the interest rates decreased, the adjustable rate on their mortgage also decreased.

► How high can an adjustable rate mortgage go?

Most adjustable rate mortgages have a "cap". A cap is an interest rate limit. The cap rate is typically 5% over the start rate. For example, if the start rate is 4% and the cap rate is 5%, then the maximum interest could go as high as 9%. Ouch!

► Should I get a fixed or adjustable rate mortgage?

Adjustable rate mortgages can save you a lot of money if you will be paying off the mortgage before the rate changes. For example, if you know that you will be transferred during the "fixed" rate period, an adjustable rate mortgage can save you money. Do you believe that the interest rates will be going lower? If so, then an adjustable rate mortgage would be your choice. Ask a lender to calculate the (highest) adjustable rate mortgage payment, year over year and compare the payment to the fixed rate mortgage. 

► What is an arm mortgage?

The word "arm" is short for adjustable rate mortgage.

► What is the difference between a fixed rate and an adjustable rate mortgage?

The fixed rate mortgage will guarantee you the same principal and interest payment over the life of the mortgage. If you take out a thirty year mortgage, the 1st payment (principal and interest) will be the same as the 360th payment.

As the name implies, an adjustable rate mortgage can change the monthly mortgage payment . . . up or down.
Learn more about adjustable rate mortgages with the Federal Reserve Board Consumer Handbook on Adjustable Rate Mortgages.pdf