What is an adjustable-rate mortgage (ARM)?

An adjustable-rate mortgage (ARM) is a loan with an initial fixed-rate period and an adjustable-rate period. The interest rate does not change during the fixed period, but once the adjustable-rate period is reached, rates are subject to change every 6 months or every 1 year, depending on the specific product.

One way to think of an ARM is as a hybrid loan product, merging a fixed upfront period with a longer adjustable period. Most of our clients look to refinance or sell their homes before the start of the adjustable period, taking advantage of the lower rate of the ARM and the stability of the fixed-rate period.

The most common ARM types are 5/6, 7/6, and 10/6 ARMs, where the first number indicates the number of years the loan is fixed, and the second number shows the frequency of the adjustment period – in most cases, the frequency is 6 months. In general, the shorter the fixed period, the better the interest rate. However, ARMs with a 5-year fixed-term or lower can often have stricter qualifying requirements as well.

How are ARM rates calculated?

During the fixed-rate portion of the ARM, your monthly payment will not change. Just as with a fixed-rate loan, your payment will be based on the note rate that you selected when locking your rate.

The interest rate you will pay during the adjustable period is set by the addition of two factors – the index and the margin, which combine to make the fully indexed rate.

Index

The index rate is a public benchmark rate that all ARMs are based on, typically derived from the short-term cost of borrowing between banks. This rate is determined by the market and is not set by your individual lender.

Most ARMs nowadays index to the Secured Overnight Financing Rate (SOFR) but some other common indices are the Constant Maturity Treasury (CMT) rate and the London Interbank Bank Offered Rate (LIBOR), which is being replaced in the United Sates by the SOFR.

The current rates for any of these indices is readily available online, providing transparency into your final rate calculation.

Margin

The margin is a rate set by your individual lender, usually based on the overall risk level a loan presents and based on the index used If the index rate referenced by the loan program is relatively low compared to other market indices, your margin may be slightly higher to compensate for the low margin.

The margin will not change over time and is determined directly by the lender/investor.

ARM Rate Calculation Example

Below is an example of how the initial rate, the index, and the margin all interact when calculating the rate for an adjustable-rate mortgage.

Let’s assume:

• 5 year fixed period, 6 month adjustment period
• 7% start rate
• 2% margin rate
• SOFR Index

For the first 5 years (60 months), the rate will always be 7%, even if the SOFR dramatically increases or decreases.

Let’s assume that in the 6th year, the SOFR Rate is 4.5%. In this case, the loan rate will adjust down to to 6.5% for the next 6 months:

2% Margin rate + 4.5% SOFR Index Rate = 6.5% new rate

Caps

Caps are limitations set during the adjustable period. Each loan will have a set cap on how much the loan can adjust during the first adjustment (initial adjustment cap), during any period (subsequent adjustment cap) and over the life of the loan (lifetime adjustment cap).

NOTE: Caps (and floors) also exist to protect the lender in the event rates drop to zero to ensure lenders are adequately compensated regardless of the rate environment.

Example of How Caps Work:

Let’s add some caps to the example referenced above:

• 2% initial adjustment cap
• 1% subsequent adjustment cap
• 5% lifetime adjustment cap
• 5 year fixed period, 6 month adjustment period
• 7% start rate
• 2% margin rate
• SOFR Index

If in year 6 SOFR increases to 10%, the caps protect the client from their rate increasing to the 12% rate we calculate by adding the index and margin together (10% index + 2% margin = 12%).

Instead, because of the initial adjustment cap, the rate may only adjust up to 9%. 7% start rate + 2% initial cap = 9% new rate.

If 6 months later SOFR stays at 10%, the rate will adjust up once again, but only by the subsequent cap of 1%. So, instead of going up to the 12% rate commanded by the index + margin calculation, the second new rate will be 10% (1% adjustment cap + 9% rate = 10% rate).

Over the life of the loan, the maximum rate a client can pay is 12%, which is calculated by taking the 7% start rate + the 5% lifetime cap. And, that rate can only be reached by the steady 1% adjustment caps.

When is the best time for an ARM?

ARMs are market-dependent. When the traditional yield curve is positive, short-term debts such as ARMs will have lower rates than long-term debts such as 30-year fixed loans. This is the normal case because longer maturity means larger risk (and thus a higher interest rate to make the risk worth it for investors). When yield curves flatten, this means there is no difference in rate from an ARM to a fixed-rate option, which means the fixed-rate option is always the right choice.

In some cases, the yield curve can even invert; in these rare cases, investors will demand higher rates for short term debt and lower rates for long term debt.

So, the best time for an ARM is when the yield curve is positive and when you do not plan to occupy the property for longer than the fixed rate period.

What are interest rates for ARMs?

The main appeal of an ARM is the lower interest rate compared to the security offered by fixed-rate alternatives. Depending on the financing type, the difference between an ARM and a fixed-rate loan can be anywhere from 1/8% to 1/2% on average. Jumbo loan products often have the most noticeable difference for ARM pricing, since Fannie Mae and Freddie Mac tend to incentivize the purchases of less risky loans for conforming loan options