March 25, 2022
Now that rates are rising, our members are starting to ask about adjustable-rate mortgages (ARMs.) These variable rate loans received a bad name during the 2008 financial crisis. But that was mainly because unqualified borrowers were given loans they couldn’t afford once their rate adjusted. But with stricter oversight – ARMs have become popular again. And these lower rates are an excellent way for some borrowers to save. We have put together this guide to explain an ARM's ins and outs.
What Are the Components of an ARM Loan?
ARMs have two distinct periods, the fixed-rate period and the adjustable period.
- Fixed-rate period – ARM loans begin with their fixed-rate period. The loan's rate will not change during this time. The length of the fixed rate is usually from 3 to 10 years, but some have 15 year fixed periods too.
- Adjustable-rate period – after the fixed-rate period concludes the ARM transitions to its adjustable-rate period. The adjustment period will continue for the life of the loan. During this time, the payment will change, up or down. Depending on the loan terms, the change is usually every 6 or 12 months.
Adjustable-Rate Mortgage Terms
An adjustable-rate mortgage (sometimes called a variable rate) has several components. That makes them a bit harder to understand than a typical fixed-rate mortgage.
When you see an ARM listed, it will look like this:
- 5/6m ARM or 5/1 ARM
You will have a number with a slash "/" and a second number or number and an "m."
So a 5/6m ARM has a five-year fixed-rate period. And if it is a 30-year ARM, the last 25 years will have the adjustable-rate period. The 6m means that the rate will adjust every six months.
If it were a 5/1 ARM, it would change annually after the initial fixed five years.
The rate that is used for the adjustment period is often based on an index rate called the Secured Overnight Financing Rate (SOFR), and the total rate is usually based on this formula:
- 30 day average of SOFR (Index) + (Margin)
The margin will usually range between 2.74% and 2.76%. Although the margin stays constant for the life of the loan, the SOFR index's value varies.
The New York Federal Reserve maintains the SOFR index, and you can access the current rates here.
ARMs have three caps that come into play after the fixed-rate period ends:
- Initial Adjustment Cap – That’s the maximum a rate can increase when transitioning from the fixed-rate period to the adjustable-rate period. Generally, the initial adjustment cap will range from 2% to 5%.
- Subsequent Adjustment Cap – That’s the maximum a rate can increase after each adjustment period (that is where the 6m or 1 come into play). In most cases, this cap won’t exceed 2%.
- Lifetime Adjustment Cap – The most that a rate can increase above your initial fixed rate for the life of the loan. Generally, this will be 5%.
For any ARM that you’re looking at, have your loan advisor go over what the rate starts at and what the maximum rate could be.
ARM Mortgage Loan Example
Here are some comparisons:
ARMs rates are for the fixed period, then adjust
You can see that every ARM loan has a lower rate than a fixed-rate loan. This difference means that the ARMs' monthly payments will be cheaper during the ARM's fixed period. Depending on the market, the rate will either go up or down after the fixed period ends.
If you choose the highlighted 10/1 ARM, your rate will be 3.375% for the first ten years of the loan. Then for the remaining 20 years, it will be adjusted annually with the SOFR + Margin formula.
Do Adjustable Rates Ever Go Down?
Yes, they do. When the 30-day SOFR average plus margin is lower than the current adjustment period rate, the rate will go down when a new adjustment period comes around. And so will the mortgage payment.
This is especially beneficial if you are in a market where rates are high and expected to drop. The rates can drop as much as the caps allow.
Who Are ARMs Good For?
A variable-rate loan is good for a borrower who feels comfortable knowing their rate will change after the initial fixed period.
It’s also good for borrowers who plan to move into a home for a few years, renovate and fix it up, and sell it. Having a lower payment could mean that you’re able to buy a bigger house to rehab and make more when you sell it.
ARMs Are Gaining Popularity Again
Now that rates are beginning to climb, borrowers are looking to save with ARMs. For those who will likely stay in their homes, you will probably want to find a fixed-rate loan and take advantage of the rates that are still historically low. If you are confident you will move in the next ten years, an ARM could be the way to go.
To learn more about PenFed loans or what loan is right for you: