Adjustable Rate Mortgage: ARM Rates, Types & More

An adjustable rate mortgage (ARM), or variable rate mortgage, is a home loan that has a periodically changing interest rate. Typically, the initial rate on an adjustable rate mortgage is lower than on fixed rate mortgages, averaging 4.38 percent. That rate can climb during the loan term, making ARM loans more unpredictable and riskier over time.

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How an Adjustable Rate Mortgage Loan Works

The ARM loan works by having an initial set period of time, usually five or seven years, that the interest rate is fixed, similar to a fixed rate mortgage. However, once that period is up the loan adjusts and the interest rate can fluctuate. This means that after the initial fixed rate period, your rate can go up or down depending on the index and margin of the loan. This rate adjustment typically occurs once per year.

In order to understand ARM loans, you need to know what affects them, which includes something called an index. The index of the loan is the benchmark interest rate that reflects current market conditions, typically set by the one year LIBOR (London Inter Bank Offer Rate).

The next term to be familiar with is the margin. The margin of your ARM loan is the number that can adjust and is set by lenders. It’s the fixed percentage rate added to the indexed rate to determine the total rate of the ARM. The margin can be negotiated with your lender, and typically the higher your FICO score and the higher your salary and down payment are, the lower you can negotiate your margin. The index plus the margin equals your ARM interest rate.

Index + Margin = Interest Rate on an Adjustable Rate Mortgage

For example, if you have a 5/1 ARM, it means that your rate is fixed for the first five years of the loan. After that, the loan can adjust once per year for the remainder of the loan term, which is typically 30 years. 5/1 ARMs and 7/1 ARMs are the most popular types of adjustable rate mortgages. They both have loan terms of 30 years.

There will typically be a cap on the rate, meaning it can never go above a certain interest rate. Each lender sets the rate cap so it varies; some caps are as high as 12 percent, which is a big jump from the average 5/1 ARM of around 4.38 percent. Keep in mind that 12 percent is the higher end of the spectrum, and caps typically range from 7 percent to 12 percent.

It’s important to know your cap and to make sure you can afford it before you agree to obtain an adjustable rate mortgage because you don’t want to get stuck with a loan you can’t afford and risk losing your home or rental property.

Adjustable Rate Mortgage Risks

Some of the risks associated with an adjustable rate mortgage include:

An interest rate that rises and makes the monthly mortgage payment no longer affordable
Being stuck with an ARM loan because you can’t sell the home or refinance before the variable rate period begins
Not understanding the type of ARM loan you obtain—they can be complex, which can result in losing the property to foreclosure because you didn’t know what you were signing up for and can’t afford it

Types of Adjustable Rate Mortgages

The most common type of adjustable rate mortgage is the hybrid ARM—that’s the one a lender will typically advertise their rates and terms for. However, there are three common types of adjustable rate mortgages. They are hybrid ARMs, interest only ARMs and payment option ARMs.

The three most common types of adjustable rate mortgages are:

1. Hybrid Adjustable Rate Mortgage

Hybrid ARMs typically come in 3/1, 5/1, 7/1, 10/1, and 15/15 ARMs. The first number is the number of years that the interest rate is fixed. The second number is how many times per year the interest rate can adjust.

A common hybrid ARM loan is a 7/1 loan with a 5/2/5 cap. This means that during the first seven years of the loan, the interest rate stays the same. However, if you keep the loan past year seven, the rate can increase by a maximum of five percentage points over the initial rate. Ever year after the eighth year, your rate can adjust by a maximum of two percentage points, but never exceeding a maximum of five points over your initial interest rate.

The 5/2/5 cap isn’t something that a lender advertises, so you will need to ask about it when choosing lenders—and it can be difficult to understand. Basically, the first number, the 5 in this example, is the number of points the rate can increase by once the fixed rate period is over. The next number, the 2, is the maximum amount of percentage points your rate can increase per year and the last number, the 5, is the total maximum amount of percentage points your rate can increase by during the duration of the loan.

For example, if your initial rate is 4 percent, your rate can go up by 2 percent each year, and the maximum that your rate can be is 9 percent.

2. Interest Only Adjustable Rate Mortgage

An interest only ARM gives you a certain number of years that you pay interest only on your loan. This is typically between three and ten years. Then, the remainder of the loan is made up of principal and interest payments. These loans aren’t as common as hybrid loans because you see a significant jump in monthly payments from paying a fixed rate, interest only payment to then paying interest and principal and an adjustable rate. However, if you want initially lower monthly mortgage payments, you could consider an interest only ARM.

The interest only period typically ends at the same time the fixed rate period ends. For example, if you have a 3/1 loan, then the first three years you pay interest only payments on a fixed rate loan. After year three, you pay interest plus principal on a loan with a rate that can adjust once a year.

3. Payment Option Adjustable Rate Mortgage

These are the least common types of ARMs but a few lenders still offer them. They let the borrower choose the type of monthly payment they make during a set period of time. The borrower can choose to make an interest only payment, a fully amortized payment with both principal and interest, or a minimum payment that doesn’t pay all of the interest that is due.

These payment options typically last for five years, after which the loan resets and goes to principal and interest payments, which can mean a large jump in monthly mortgage payments if the borrower was only paying interest or a minimum monthly payment. Typically, these types of specialty adjustable rate mortgage loans are complicated, rare and reserved for wealthy, savvy investors who ask for them. They’re not advertised and rates and terms generally aren’t disclosed until you are working with a lender.

Who an Adjustable Rate Mortgage Is Right For

An adjustable rate mortgage loan can be right for owner occupants who plan on refinancing or selling their home before the variable rate period begins. They can take advantage of a low rate and benefit from a lower monthly mortgage payment. They may also be betting on lower rates in the future or rising property value.

“Adjustable rate mortgages can be right for small business owners as a cash flow management tool. In months when business cash flow is up, you can choose to prepay home loan principal by sending in more than you owe. When cash flows are down, you pay just what you owe, and no more.” – Henry Brandt, Branch Manager, Planet Home Lending

ARMs for Real Estate Investors

Adjustable rate mortgages can also be right for real estate investors who want to take advantage of initially low interest rates, thus increasing their monthly cash flow. Investors may also use ARMs to be able to qualify for a more expensive rental property than they would qualify for with a fixed rate mortgage. Investors can also use adjustable rate mortgages if they plan to refinance or sell their rental property before the fixed rate period ends.

Adjustable Rate Mortgage Rates, Terms & Qualifications

Adjustable rate mortgage rates vary by lender, but they are typically based on the one-year LIBOR index as well as the borrower’s qualifications. Terms are generally 30 years for all adjustable rate mortgages and qualifications vary by lender.

Current ARM Rates & Costs

Interest rates are typically the cost of borrowing only the principal loan amount and are expressed as a percentage. They’re typically lower than an APR because the APR includes interest plus principal plus other costs associated with the loan, including discount points and broker fees. APR is also expressed as a percentage.

Adjustable rate mortgage rates are typically:

3/1 ARM Rate: 4.13%+
5/1 ARM Rate: 4.25%+
7/1 ARM Rate: 4.28%+
10/1 ARM Rate: 4.43%+
Prepayment Penalty: Typically none, but it varies by lender and type of ARM loan
Appraisal: Usually about $500
Closing Costs: Typically 2 – 5%

These rates are for the most common ARM loans (hybrid ARMs). Typically interest only and payment option ARMs are considered specialty loan products and you would need to contact a lender directly for specific rates and terms for them.

ARM Repayment Terms

Adjustable rate mortgage terms are generally:

Repayment Term: Typically 30 years
Fixed Rate Term: Generally the first 3, 5, 7 or 10 years of the loan

Adjustable Rate Mortgage Qualifications

Adjustable rate mortgage qualifications are typically:

Minimum FICO Score: 640 (check yours free here)
Down Payment for Owner Occupant: Typically 5 – 20%
Down Payment for Investment Property: Typically 20%+ but some lenders will consider 10% with a higher FICO score, stable employment and cash reserves
Bank Statements: Typically a lender may ask for the last three months
Proof of Income: Typically for the past 2+ years in the form of tax returns and/or pay stubs
Exit Strategy: This really varies by lender, but you need to prove you can afford the maximum monthly mortgage payment either by showing cash reserves, upcoming promotion, plans to refinance or sell the property, etc.

Each lender has their own requirements, but regardless of the type of ARM loan you apply for, a lender will usually have a minimum FICO score and down payment amount and will need to verify proof of income so they’re confident you can afford the loan.

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ARM Loan Repayment Example

Typically, if you want to figure out what your monthly mortgage payment will be, you should use an adjustable rate mortgage calculator that calculates it for you. However, we’re going to go through the steps that the calculator takes to figure out your ARM loan monthly mortgage payment.

Let’s assume that you want to purchase a house for $500,000 and are going to use a 5/1 ARM loan with an initial rate of 4.38 percent.

Typically, ARM loans will have a cap on them so the rate can’t go higher than that cap. The ARM loan calculator will use a 30-year amortization table to calculate what your mortgage payment for the first 60 months (five years) will be: $2,497.90 per month.

Let’s assume that your interest rate is capped at 12 percent, so this means your monthly mortgage payment can be as high as $3,508.22.

That is $1,010.32 more than your initial monthly payment, which could make the adjustable rate mortgage payment unaffordable, which is why it’s important to know when your ARM loan adjusts and the cap rate, and to have an exit strategy (such as refinancing or selling your property).

How to Apply for an Adjustable Rate Mortgage

Applying for an adjustable rate mortgage is the same as applying for an investment property loan, except that you will receive some extra disclosures at settlement about the type of mortgage, how an ARM loan works, and its cap rate. It’s important to go over anything you don’t understand in these documents with your loan officer.

There are typically four steps when applying for an ARM loan:

1. Choose an Adjustable Rate Mortgage Lender

After you decide that an adjustable rate mortgage is right for you, choose a lender to work with. This is the first step in the application process and is important because you want to work with a reputable lender that explains the process to you, offers competitive rates, and is communicative and timely in responding.

It’s a good idea to compare two to three lenders and their adjustable rate mortgage rate, terms, and qualifications, as well as what areas they lend in. Look for reputable lenders that lend in the area you want to purchase a property in. It’s a good idea to start with your bank or credit union because you already have a banking relationship with them, so you may get better rates and more lenient qualifications.

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2. Get Pre-Approved for an Adjustable Rate Mortgage

Getting pre-approved for an adjustable rate mortgage is generally the most important step of the approval process. This is because it lets you know the maximum amount you can qualify for, which can steer your property search and help you set your budget. It also is the step when you receive a pre-approval letter, which you need before you can make an offer on a property.

Remember that the pre-approval amount should be considered the very top of your price range; you need to make sure you can afford the property and all associated expenses like HOA fees, maintenance, and utilities. Think of the lender’s pre-approval amount as a ceiling, and then try to find properties that are less than that amount. This is especially important for ARM loans because your payments may increase, and if you purchase a property at the top of your price range, you may no longer be able to afford it once the rate adjusts.

The pre-approval process usually takes one to three business days; the lender will run your credit and request documentation of proof of income such as pay stubs, bank statements and/or tax returns. Each lender has a different pre-approval process and whatever they don’t ask for during the pre-approval phase, they will want to see during underwriting. You should ask the lender up-front what documents they require and when they need them so you’re prepared and can speed up the application process.

3. Begin the Underwriting Process for Your Adjustable Rate Mortgage

After you get pre-approved for an adjustable rate mortgage, it’s time to submit any outstanding documents and go through what’s called the underwriting process. This is the time when the lender will thoroughly examine your proof of income documents, look through your credit history, and look at your debt to income ratio. During this time, the lender will order an appraisal to see how much the property is worth. The appraisal fee usually needs to be paid out of pocket and is typically around $500.

The lender may want to see the following documents:

Bank Statements: Typically three to six months
Tax Returns: Generally two years
Pay Stubs: Typically your two most recent

Each lender has a different underwriting process and they generally look at the borrower’s overall financial standing, the property value, and the location. The lender also wants to know how you’re going to afford to repay the adjustable rate mortgage if the interest rate increases.

The lender will generally accept you if you meet their other criteria and your current income shows you can afford a higher monthly payment, or if you plan to refinance or sell the property before the rate adjusts.

4. Close on Your Adjustable Rate Mortgage Loan

The final step is to close on the loan, which is typically 30 to 45 days from the time you apply for the ARM loan. During this step, the lender reviews the property appraisal and issues a final mortgage approval. Once you receive this approval, you can schedule the settlement and the title company generally sends out a closing notice to all parties with the date and time of settlement.

The settlement or closing typically takes about 60 to 90 minutes and is held at the title company’s office so they can copy all documents and give out signed copies to each party. You need to bring your identification and a certified check. This is the time when you will pay the closing costs, which are typically two to five percent of the purchase price, and the lender will give you a breakdown of them ahead of time.

ARM vs. Fixed Rate Mortgage

As we discussed throughout the article, an ARM mortgage is a home loan that has an interest rate that changes periodically after its initial fixed rate period. Typically, after the fixed rate period ends, the rate changes once per year for the duration of the loan term.

This is in contrast to a fixed rate mortgage, which has the same mortgage rate for the entire term (typically 15 or 30 years). If you have a fixed mortgage, you may initially receive a slightly higher rate than that of an ARM, but you don’t have the risk of your rate and monthly payment going up during the term of the loan.

ARM vs. HELOC

Although home equity lines of credit (HELOCs) typically have variable rates, they are not considered ARMs. Both HELOCs and ARMs can have the risk of rising interest rates and rising monthly mortgage payments. They’re also both based on a benchmark rate plus a margin. However, that’s where the similarities end.

HELOCs are loans that are set up as a line of credit with a draw period during which the borrower can use the line of credit and a repayment period (and during which time the borrower must repay the loan). They can be used in place of first mortgages or as second mortgages. Draw periods are usually five to ten years, and the borrower only needs to pay the interest on the loan. However, during the repayment period, which is usually 10 to 20 years, the borrower must repay the principal of the loan.

Pros and Cons of Using an ARM Loan

As with any type of mortgage, there are both pros and cons of an adjustable rate mortgage loan. The main benefits of an adjustable rate mortgage loan are that it has a low initial monthly interest rate, which results in a lower monthly mortgage payment when compared to a fixed rate mortgage. The main disadvantage of an adjustable rate mortgage loan is that the rate may go up over time and increase your monthly mortgage payment until it becomes unaffordable.

Pros of Using an ARM Loan

Benefits of an adjustable rate mortgage loan include:

Low initial interest rate, therefore low initial monthly mortgage payment
Typically no prepayment penalty
Investors can take advantage of greater cash flow with a lower monthly mortgage payment
Flexibility so that you can sell the property or refinance before the ARM’s fixed rate period ends
Your mortgage payments could get smaller if interest rates decrease

“The advantage of an ARM is an initial savings on interest. Over the life of the loan, you can save thousands of dollars, depending on your loan amount and the interest rate environment throughout the life of your loan.” – Pamela A. Patenaude, Mortgage Loan Officer, Freedom Credit Union

Cons of Using an ARM Loan

Cons of an adjustable rate mortgage loan include:

Your adjustable rate mortgage rate may increase, causing your monthly mortgage payment to increase
You aren’t able to sell or refinance the property before the variable rate period begins
Your investment property rental income doesn’t increase as much as your mortgage payment, so you’re cash flow negative

ARM Loan Frequently Asked Questions (FAQs)

Below, we are going to answer some frequently asked questions about ARM loans. If you have additional questions or would like to comment on the topic, please visit our forum.

How Does a Five-Year ARM Work?

A five-year arm is an adjustable rate mortgage loan with a fixed rate for the first five years of the loan term. After the five years are up, the interest rate can adjust, which means the monthly mortgage payment can also adjust. If the ARM loan is 5/1, it means that the adjustable rate mortgage rate is fixed for five years and can then adjust once per year for the remainder of the loan term.

What Is the Difference Between an ARM Loan and a Balloon Mortgage?

A balloon mortgage is a loan in which a large portion of the principal is repaid in one payment at the end of the loan term. A balloon mortgage typically has a fixed rate that is amortized over 30 years, but the term is generally between five and seven years. At the end of the term, a lump sum is due, called the balloon.

This is in contrast to an ARM loan, which is typically a 30-year loan that has an initial fixed interest rate, after which the rate adjusts periodically and no balloon payment is due at the end of the term.

How Can You Pay Off Your Mortgage Faster?

If you want to pay off your investment property mortgage faster than its intended term, you want to first find out if there is a prepayment penalty. This is the fee that a lender charges the borrower for paying off their loan early. The fee is charged because the lender will be making less in interest if the borrower pays if off early. Typically, most ARM loans don’t have prepayment penalties, but check with your lender just to be sure.

Once you know about whether or not there’s a prepayment penalty, you can increase each of your monthly payments or make bi-weekly payments to pay off your mortgage faster. If you make bi-weekly payments, you will make one extra mortgage payment per year.

Bottom Line

An ARM loan is a variable rate mortgage used by owner occupants and investors because the initial rate is typically lower than fixed rate mortgages. The adjustable rate mortgage rate is typically fixed for a certain period of time and then adjusts. Average adjustable rate mortgage rates are 4.38 percent.

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Adjustable Rate Mortgage: ARM Rates, Types & More