Adjustable-rate mortgages (ARMs) are loans whose interest rate can vary during the loan's term. These loans usually have a fixed interest rate for an initial period of time and then can adjust based on current market conditions. The initial rate on an ARM is often lower than the rate that would be available to the same borrower, at the time, for a fixed rate mortgage. On the other hand, after the initial fixed period, the rate on an ARM can change to be higher than a fixed-rate mortgage would have been.
Adjustable-rate mortgages are usually amortized over a period of 30 years with the initial rate being fixed for anywhere from one month to 10 years. After the initial fixed period, the rate typically gets adjusted periodically. A loan that is fixed for three years and then adjusts once a year, for example, is called a “3/1 ARM.”
At the adjustment date, the rate is set to the value of an “index” rate plus a “margin.” The index is the financial instrument that the ARM loan is tied to such as: 1-Year Treasury Security, LIBOR (London Interbank Offered Rate), Prime, 6-Month Certificate of Deposit (CD), and the 11th District Cost of Funds (COFI). The loan terms identify the index that will be used and also specify the margin. Suppose that when the adjustment date comes, the index used for a given loan is at 3.25%, and the margin specified in the terms is 2.0%. Then the loan’s interest rate will be set at 5.25%.
Typically, the loan terms will limit how much an ARM’s interest rate can adjust. A loan agreement might specify a maximum interest rate for the loan; even if the index rises above that, the loan’s interest rate will not exceed the cap. A loan agreement might also limit how quickly a loan’s rate can change. Suppose your loan says the rate won’t change more than 1.5% at an adjustment. Even if the index leaps by 3%, your loan’s rate will go up by only 1.5% at that adjustment. If the index stays high, the loan rate will increase by up to another 1.5% at the next adjustment.
Some ARM loans have a conversion feature that would allow you to convert the loan from an adjustable rate to a fixed rate. There may be a charge to convert; the conversion rate is usually slightly higher than the market rate that the lender could provide you at that time by refinancing.