An ARM mortgage is Adjustable Rate Mortgage. This means that the interest rate of the loan will change with the market. If prices (interest rate) go down then your mortgage will decrease. The opposite is also true: if the market goes up, then your mortgage price will increase. The increase or decrease is reflected in your monthly payments. You will pay more during an increase in mortgage interest rates, and less during a decrease in interest.

For your protection, there is an interest rate cap – the highest interest rate allowed by your mortgage. Your actual interest rate will not be adjusted above this rate.

The process for an ARM mortgage is similar to other mortgages with the addition of fixed and adjustable periods, and the details about rate adjustments within those periods.

1. Initially, you will get a loan for the mortgage amount (home price) – balance of your mortgage after down payment.
2. Set your starting interest rate. This is the rate that your adjust rate mortgage will begin with and remain at during the fixed price period.
3. Decide your loan term (length of mortgage). Typical ranges are 15 and 30 year mortgages.
4. Figure out your interest rate cap. This is the upper limit to the possible increase of your mortgage. If your interest cap rate is 5%, then your mortgage rate will not exceed this rate. An upper limit allows you to prepare for potential monthly expenses.
5. Determine fixed interest rate period & months between adjustments. In the months before your first mortgage adjustment. You will also decide on your months between adjustments which is the amount of time that you get before an adjustment is implemented. This protects you from monthly price swings. Common “months between adjustments” is 12 months, so your price will change only once/year.
6. Determine starting monthly payment. This is the sum of your principal (loan amount without interest) and interest (payment to the lender for their services).

All things come with advantages and disadvantages. We will compare and contrast the pros and cons of Adjustable Rate Mortgages and Fixed Mortgages.

ARM

• Pros:
  • Low introductory rates.
  • Take advantage of lower interest rates if they occur.
  • For people who want to buy, but don’t plan to stay long.
• Cons:
  • Market volatility means that you will be exposed to higher interest rates that could last for any number of years meaning that you will pay more over the life of the loan than anticipated.
  • Complex. There are interest caps, margins, adjustment indexes, adjustment periods, and types of ARMs to buy.

Fixed

• Pros:
  • Simple. No need to know the difference between a 7/1 or 10/1 ARM, or what a hybrid ARM is.
  • Predictable. Monthly payments are the same across time.
  • Protection. Regardless of what the market does, or the volatility, you will pay the same rate.
• Cons:
  • You missed out on lower rates if they drop. You would have to refinance to take advantage of a lower interest rate.
  • Could cost more. Missing out on the lower market is one reason, and another is that the protection against market volatility costs a little more.
  • Typically cannot be customized so they’re the same from lender to lender.

The main advantage of an adjustable rate mortgage is the low introductory rate and the potential to take advantage of falling interest rates.

The big disadvantage of an adjustable rate mortgage is the exposure to potential higher interest rates.

A 5 year ARM is actually a 5/1 ARM loan. This means that the first 5 years the interest rate is fixed.

Yes, you can pay off an ARM Mortgage Early. The extra amount you pay each month will have to be adjusted when your rate changes.

In 2018, according to Ellie Mae, ARMs made up just 4% of all mortgages sold.

Adjustable Rate Mortgages are not inherently bad, but they have a con like all loans. When rates go up, so will your interest rate. There is a cap though for buyer protection.

The three indexes that ARMs are tied to are the One Year Treasury Bills, 11th District Cost of Funds Index, & the London Interbank Offered Rate.