An adjustable rate mortgage (ARM), in the United States, is a type of mortgage loan, in which the interest rate offered by the entity changes or adjusts throughout the duration of the loan.
Therefore, we are talking about a mortgage with a variable interest rate, of those of a lifetime, but which in the United States receives that name. That is, it is called an adjustable rate mortgage or, for its acronym in English, ARM.
A mortgage loan of this type, that is, an ARM, is a mortgage loan in which the interest rate changes throughout the loan. In other words, this rate is adjusted based on the behavior shown by the economy at all times. Therefore, at the beginning of the loan we could find that the interest rate is low and attractive, but, over time, it can increase rapidly depending on how the economy evolves.
Instead, we have the mortgage with a fixed interest rate. That is, the one in which an agreement is reached with the entity and a fixed interest rate is established, which will not vary and will remain stable until the end of the loan.
Features of an Adjustable Rate Mortgage (ARM)
Among the characteristics of this type of mortgage loans, it is worth mentioning the following:
- It is a type of mortgage loan.
- It is called this way in the United States.
- In this type of loan, the interest rate is variable.
- The rate is determined by the behavior of the economy.
- This, through a calculation in which an index is used and a margin is applied.
- To make them more attractive, banks offer very low introductory rates.
- Although, subsequently, this rate can go up quickly.
- An initial period is established, in which the rate is fixed, and then it is adjusted based on the economy.
- Some entities establish a minimum and maximum rate, so we speak of a rate that would oscillate in a range.
- It is the opposite type of mortgage to the fixed rate mortgage, in which the interest rate does not change.
Why does the interest rate on an ARM vary?
As we can see in the economic indicators, economic growth, inflation and, in general, the economy is not something constant, but rather presents a behavior that varies over time. For this reason, today we can see low interest rates, due to the economic situation in the countries, but tomorrow the situation could change. In other words, interest rates could rise and, with it, the cost of money.
For this reason, banks offer various types of mortgage loans, depending on our interests.
Among the most common, we find the fixed-rate mortgage and the variable-rate mortgage. The latter is the one we are talking about in this article, but with the peculiarity that ARM is the American denomination.
In ARM mortgages, the bank offers an initial interest rate, but this can vary throughout the loan. To do this, the bank uses a formula by which it establishes that the interest rate is made up of an index plus a margin applied by said financial institution.
The index is a measure that, based on the central bank interest rate, reflects trends in the global economy. In the United States, the most commonly used indices are the US Prime Rate and the Constant Maturity Treasury (CMT) rate.
On the other hand, the margin, which is added to the index, is an additional percentage that the lender charges the client.
Based on this index and the margin applied, the interest rate will be determined at any given time.
However, he is obliged to indicate to the client how his interest rate is calculated, and based on what indices.
When does the interest rate on an ARM mortgage vary?
As we have emphasized in the article, the interest rate on a mortgage of this type is not fixed or permanent, as is the case with a fixed-rate mortgage.
The interest rate on an ARM remains in effect for a limited period of time.
For this reason, it is common to find that, when an ARM is announced, it is accompanied by an indicator of the type: 5/6m or 7/1m.
What does this mean?
The first number reflects the duration of the initial interest rate offered by the bank. Regarding the second number, this shows how often the rate will change after the period subject to the initial interest rate has expired.
Therefore, in a 7/6m ARM mortgage, for example, the initial interest rate would remain stable for the first 7 years, starting to adjust said rate every 6 months, after those first 7 years.
What is an introductory rate on an ARM mortgage?
In order to sell more mortgages, banks or lenders campaign in which they offer ARM mortgages at a very low interest rate, despite warnings that this interest rate will change in the future.
This is what we know as the “introductory rate”.
The introductory rate is the rate offered by the bank at a discount, its objective being for the client to sign and take out the mortgage. This introductory rate will remain in force for a previously established time, taking on that variable nature when said time expires.
Differences between an ARM mortgage and a fixed rate mortgage
Although fixed-rate mortgages, as their name suggests, differ from ARMs in that the interest rate of the former is fixed, while the latter is variable, we must say that there are other differences that should be underlined.
Among these, it is worth highlighting the following:
- In fixed-rate mortgages, the interest rate is set at the beginning of the loan and does not change until the loan ends. In ARMs this is not the case, as we have seen throughout the article.
- Regarding the principal and interest, these remain constant throughout the life of the loan. In ARMs, and due to their characteristics, these vary throughout the loan.
- In a fixed rate mortgage we know the interest that will be charged from the beginning. In an ARM, these interests are unknown, since the interest rate can vary and cause us to pay more interest.
Advantages and disadvantages of an ARM mortgage
Finally, we must know that when we talk about a fixed-rate mortgage, or an ARM, both can present as many advantages as disadvantages for customers.
For this reason, let’s see some of the main advantages and disadvantages of, specifically, the ARM mortgage.
Advantages of the ARM mortgage
Among the advantages offered by this type of mortgage, it is worth mentioning the following:
- The interest rate, at certain times, is lower than the interest rate offered by the fixed ones.
- It allows, therefore, to take advantage of the situation to save on the mortgage payment.
- In the worst case scenario, ARM mortgages establish maximum and minimum rates, so we are talking about a security fork that guarantees a maximum interest, despite the fact that the situation is unfavorable.
Disadvantages of the ARM mortgage
On the other hand, among the inconveniences that a client encounters when analyzing this type of mortgage, it is worth highlighting the following:
- It is a more complex type of mortgage loan.
- We do not know the interest that we will pay at the end of the loan, so we could end up paying more than with a fixed-rate mortgage.
- In case we need to refinance, this type of mortgage offers greater limitations.