An adjustable rate mortgage (ARM), variable rate mortgage or floating rate mortgage is a mortgage loan where the interest rate on the note is periodically adjusted based on an index. An Adjustable Rate Mortgage, or ARM as it is popularly referred to, is a loan option whose interest rate changes after a fixed number of years (typically 5 or 7 years). After this fixed period, the rate will likely adjust, either increasing or decreasing your monthly payments.

An ARM is a common alternative to a fixed rate mortgage, typically offering lower interest rates than you would be able to obtain with a fixed rate mortgage. While potentially unpredictable, they can be a great home loan alternative in comparison to a long term mortgage like a 30 year-fixed rate mortgage.

Why Should I Choose an ARM?

Are you thinking about moving or upgrading your home in a few years? Adjustable rate mortgages are a cheaper way to buy a home when you don’t plan on staying in it past 7 years, due to their lower interest rates and ultimately, lower monthly payments.

If you want the lowest rate currently available, an ARM can provide you with it. ARMs transfer part of the usual “interest rate risk” carried by all home loans, from the lender to the borrower since the borrower is taking advantage of lower initial payments by risking the possibility that the mortgage interest rate could increase after the initial term.

In addition, an ARM is a great way to qualify for a higher loan amount, allowing you to purchase a more valuable house. People who take out very large mortgages tend to get a 1-year ARM then refinance it to keep their rate from increasing. Thanks to the low rates available with an adjustable rate mortgages, you’ll be able to buy a more expensive home while taking advantage of the lowest possible mortgage payment available.

Characteristics of the ARM loans

How an ARM Works

The borrower’s interest rate is determined by the cost of money at the time the loan is made. Then the rate is tied to a recognized index your lender is currently using for this loan. Your future interest adjustments are then based on the upward or downward movements of this index. An index is a reliable statistical report that reflects the approximate change in the cost of money. Some examples of this would be the monthly average yield on three-year treasury securities, or the national average mortgage contract rate for purchases on previously occupied homes. The rise and fall of your payments will fluctuate with the index preferred by the lender for this loan program when your loan was made.

To insure that the expenses of administration and profit are included in the payments to the lender, it is necessary for the lender to add a margin to the index. Different lenders use different margins, which explain the variation in interest rates offered for the same loan program. Margins range from 2% to 4% and are added to the index to come up with the interest rate you pay (margin + index = interest rate). It is the fluctuation of the index rate that causes the borrowers interest rate to increase or decrease.

ARM home loans are based on Index

Variable or adjustable loan is loan whose interest rate, and accordingly monthly payments, fluctuates over the period of the loan. With this type of mortgage, periodic adjustments based on changes in a defined index are made to the interest rate. The index for your particular loan is established at the time of application. All adjustable rate mortgages have an adjusting interest rate tied to an index. Six common indices in the United States are:

Well known ARM indexes include:

• Constant Maturity Treasury (CMT)
• Treasury Bill (T-Bill)
• 12-Month Treasury Average (MTA or MAT)
• Certificate of Deposit Index (CODI)
• 11th District Cost of Funds Index (COFI)
• Cost of Savings Index (COSI)
• London Inter-Bank Offering Rates (LIBOR)
• Certificates of Deposit (CD) Indexes
• Bank Prime Loan (Prime Rate)
• Fannie Mae’s Required Net Yield (RNY)
• National Average Contract Mortgage Rate