Adjustable-Rate Mortgage (ARM)

Overview

An Adjustable-Rate Mortgage (ARM) allows borrowers to initially enjoy lower interest rates compared to fixed-rate mortgages. The initial period typically features a fixed interest rate and can last anywhere from a few months to several years. After the initial period, the interest rate resets periodically based on current market conditions. The rate adjustments are tied to an indexed rate, such as the one-year Treasury bill rate, plus a fixed margin.

Key Components:

Initial Interest Rate: The fixed rate applied during the initial period of the loan.
Adjustment Period: The interval at which the interest rate on an ARM is reset after the initial period.
Index: A financial indicator used by lenders to measure interest rate changes, e.g., the one-year Treasury bill rate.
Margin: A fixed percentage added to the indexed rate to determine the adjustable interest rate.

Examples

Example 1: A borrower takes out a 5/1 ARM loan to purchase a home. For the first five years, the interest rate is fixed at 3%. After five years, the interest rate will reset annually based on the one-year Treasury rate plus a 2% margin.
Example 2: Samantha decides on a 7/1 ARM with an initial interest rate of 2.75% for seven years. After this period, the rate will adjust every year according to the prevailing interest rates tied to an index plus a 2.5% margin.

Frequently Asked Questions

What are the advantages of an ARM?

Lower Initial Rates: Typically lower initial rates can save borrowers money in the early years of the mortgage.
Reduces Short-Term Costs: Ideal for those planning to refinance or sell before rate adjustments occur.

What are the risks associated with an ARM?

Rate Uncertainty: Future rate adjustments can increase monthly payments.
Complexity: ARM terms can be confusing and vary by lender.

How often does the interest rate adjust?

This depends on the specific terms of the ARM but common adjustment periods are annually after the initial fixed period.

Can the interest rate go down as well as up?

Yes, ARM rates can go down if the index rate decreases, although they are often subject to caps which limit how much rates can change.

What happens at the end of the ARM term?

The mortgage may revert to a variable rate permanent loan unless refinanced or paid off.

Cost of Funds Index (COFI)

An index often used to determine interest rate changes for ARMs. It is calculated based on the interest expenses banks incur from borrowing.

Adjustment Index

A benchmark interest rate used to adjust interest rates of adjustable-rate mortgages (ARMs).

Fixed-Rate Mortgage (FRM)

A mortgage in which the interest rate remains constant throughout the term of the loan unlike an ARM where it may vary.

Online Resources

References

Brueggeman, William B., and Jeffrey D. Fisher. Real Estate Finance and Investments.
Geltner, David, et al. Commercial Real Estate Analysis and Investments.

Suggested Books for Further Studies

Michael C. Thomsett. Real Estate Market Valuation and Analysis.
David Reiss. The Restatement of Mortgages.
Jack Cummings. The Real Estate Investor’s Guide to Financing.

Real Estate Basics: Adjustable-Rate Mortgage (ARM) Fundamentals Quiz

### What is the primary characteristic of an adjustable-rate mortgage (ARM)? - [x] It has an interest rate that varies periodically. - [ ] It has a fixed interest rate for the entire loan term. - [ ] It is exclusively for commercial properties. - [ ] It can't be refinanced. > **Explanation:** An adjustable-rate mortgage (ARM) has an interest rate that fluctuates over time based on an indexed rate after an initial fixed period. ### What does the margin in an ARM represent? - [ ] The initial interest rate of the loan - [x] A fixed percentage added to the index - [ ] The adjustment period length - [ ] The total loan amount > **Explanation:** The margin is a fixed percentage that the lender adds to the index rate to calculate your new interest rate at each adjustment period. ### How often can the interest rate on an ARM change after the initial period? - [x] Annually - [ ] Monthly - [ ] Every five years - [ ] It never changes > **Explanation:** After the initial fixed period, the interest rate on many ARMs generally changes every year, although the exact period can vary depending on the loan terms. ### What financial index is commonly used for adjusting ARMs? - [x] One-year Treasury Bill Rate - [ ] Consumer Price Index (CPI) - [ ] Federal funds rate - [ ] LIBOR rate > **Explanation:** A commonly used financial index for adjusting ARMs is the one-year Treasury Bill Rate. ### Which borrowers might benefit the most from an ARM? - [ ] Long-term homebuyers who plan to keep the mortgage unchanged - [x] Borrowers planning to sell or refinance before rate adjustments - [ ] Those wanting stable mortgage payments - [ ] They offer the highest initial payment. > **Explanation:** Borrowers who plan to sell or refinance before the rate adjusts can benefit most from an ARM as it offers lower initial interest rates. ### What is a "5/1 ARM"? - [x] A loan with a fixed rate for five years that adjusts annually thereafter - [ ] A loan adjusting every five years permanently - [ ] Fixed-rate mortgage with five percent margin - [ ] ARM with a five-year Balloon Payment > **Explanation:** A “5/1 ARM” means the mortgage has a fixed rate for the first five years, then adjusts annually thereafter based on the index plus a margin. ### Can ARMs adjust to lower rates if the benchmark falls? - [x] Yes - [ ] No, they always adjust upwards - [ ] Only during the initial period - [ ] Only for jumbo loans > **Explanation:** ARMs can adjust to lower rates if the index on which the rate is based decreases. ### What typically happens at the end of the initial fixed-rate period for an ARM? - [x] The rate resets regularly based on the index - [ ] The rate remains fixed indefinitely - [ ] The mortgage automatically refinances - [ ] Interest stops accruing > **Explanation:** At the end of the initial fixed-rate period, an ARM’s rate typically resets regularly based on the index rate plus a predetermined margin. ### Who determines the indexed rate that dictates an ARM's adjustments? - [x] Financial markets/government statistics - [ ] Homebuyers themselves - [ ] The lender arbitrarily - [ ] Real estate agents > **Explanation:** The indexed rate used for ARM adjustments is determined by financial markets or set by government statistics, like the one-year Treasury Bill rate. ### Why might the complexity of ARMs be a drawback? - [x] Understanding rate adjustments and terms requires sophisticated knowledge. - [ ] They have higher initial payments compared to fixed-rate mortgages. - [ ] They are exclusively for commercial use. - [ ] They require higher down payments. > **Explanation:** ARMs can be complex due to rate adjustments and the diverse terms applied by lenders, requiring borrowers to have a deeper understanding or review of the mortgage terms.