Adjustable-Rate Mortgages

An adjustable-rate mortgage, or ARM, is a type of home loan that starts with a low interest rate—typically below the market rate—that may be adjusted periodically over the life of the loan. As a result of these changes, your monthly payments may also go up or down. Some lenders call this a variable-rate mortgage.

Interest rates for adjustable-rate mortgages depend on a number of factors. First, lenders look to a major mortgage index to determine the current market rate. Typically, an adjustable-rate mortgage will start with a teaser interest rate set below the market rate for a period of time, such as 3 or 5 years. After that, the interest rate will be a combination of the current market rate and the loan's margin, which is a preset number that doesn't change.

For example, if your margin is 2.5 and the market rate is 1.5, your interest rate would be 4% for the length of that adjustment period. Many adjustable-rate mortgages also include caps to limit how much the interest rate can change per adjustment period and over the life of the loan.

With an ARM loan, your interest rate is fixed for an initial period of time, and then it's adjusted based on the terms of your loan.

When comparing different types of ARM loans, you'll notice that they typically include two numbers separated by a slash—for example, a 5/1 ARM. These numbers help to explain how adjustable mortgage rates work for that type of loan. The first number specifies how long your interest rate will remain fixed. The second number specifies how often your interest rate may adjust after the fixed-rate period ends.

Here are a few of the most common types of ARM loans:

• 5/1 ARM: 5 years of fixed interest, then the rate adjusts once per year
• 5/6 ARM: 5 years of fixed interest, then the rate adjusts every 6 months
• 7/1 ARM: 7 years of fixed interest, then the rate adjusts once per year
• 7/6 ARM: 7 years of fixed interest, then the rate adjusts every 6 months
• 10/1 ARM: 10 years of fixed interest, then the rate adjusts once per year
• 10/6 ARM: 10 years of fixed interest, then the rate adjusts every 6 months

It's important to note that these two numbers don't indicate how long your full loan term will be. Most ARMs are 30-year mortgages, but buyers can also choose a shorter term, such as 15 or 20 years.

Changes to your interest rate depend on the terms of your loan. Many adjustable-rate mortgages are adjusted yearly, but others may adjust monthly, quarterly, semi-annually, or once every 3 to 5 years. Typically, the interest rate is fixed for an initial period of time before adjustment periods begin. For example, a 5/6 ARM is an adjustable-rate mortgage that's fixed for the first 5 years before becoming adjustable twice a year—once every 6 months—afterward.

Yes. You can pay off an adjustable-rate mortgage, or ARM, early. However, depending on the terms of your loan, you may be charged a pre-payment penalty.

Many borrowers choose to pay an extra amount toward their mortgage each month, with the goal of paying it off early. However, unlike with fixed-rate mortgages, extra payments won't shorten the term of your ARM loan. It could lower your monthly payments, though. This is because your payments are recalculated each time the interest rate adjusts. For example, if you have a 5/1 ARM with a 30-year term, your interest rate will adjust for the first time after 5 years. At that point, your monthly payments will be recalculated over the next 25 years based on the amount you still owe. When the interest rate is adjusted again the next year, your payments will be recalculated over the next 24 years, and so on. This is an important difference between fixed- and adjustable-rate mortgages, and you can talk to a mortgage banker to learn more.