Adjustable Rate Mortgage (ARM) FAQs
In this section you will find answers to the
most frequent questions we receive about adjustable rate mortgages.
If you have a question we do not address, please ask us
directly! Please check our Mortgage
Terms Glossary for commonly used mortgage terminology. You can read more about adjustable rate mortgages at the Federal Reserve Board.
What is an adjustable rate mortgage or ARM?
What is the advantage of an adjustable rate mortgage?
What are the components of an adjustable rate mortgage?
What are the most commmon indexes used for adjustable rate mortgages?
What is a conversion option?
Adjustable rate mortgages, or ARMs, are loans whose interest rate can vary during the loan's term. These loans have a fixed interest rate for an initial period of time, called the start rate, and then typically adjust on a yearly basis.
The start rate on an adjustable rate mortgage is almost always lower than what is offered with a 30-year fixed rate mortgage. This lower interest rate can save you hundreds if not thousands of dollars in payments per month and in the short run usually performs better than a typical 30-year fixed rate mortgage. With an adjustable rate mortgage you do not have to pay for the ability to fix the rate for a full 30 years as you do with a 30-year fixed rate mortgage. You only pay for a fixed rate for as many years as you need it, no more. This can be advantageous if you plan on being in your home with a timeline of one to ten years.
To better understand an adjustable rate mortgage, you must have a working knowledge of its components. These components are:
Start Rate The rate during the initial period of the adjustable rate mortgage in which the interest rate is fixed. This fixed period can range from 1 to 10 years.
Index The economic indicator used to determine changes to the ARM's interest rate. The loan is "tied" to this index. As the index rises and falls, so does the ARM's interest rate.
Margin The percentage points the lender adds to the index to establish the actual interest rate of the ARM. The margin remains fixed throughout the life of the loan.
Fully Indexed Rate The index plus the margin equals the fully indexed rate.
Adjustment Period The time between changes in the ARM's interest rate. If the ARM has an adjustment interval of one year, the rate (and as a result the monthly payment), may change every year, based upon the current index plus the margin.
Interest Rate Caps There are two types of interest rate caps associated with ARMs. Periodic caps limit the amount your interest rate can adjust up or down from one adjustment period to the next, and lifetime caps limit how much the interest rate can increase over the life of the loan.
These are the most common indexes used for adjustable rate mortgages:
London InterBank Offered Rate (LIBOR) The LIBOR is an average of the daily lending rates from several major English banks. It is a common international interest rate index and is used on the majority of ARM loans today. It tends to react quickly to changes in the market.
1-Year Treasury (CMT) This index is an average yield on the U.S. Treasury securities adjusted to a constant maturity of one year. This index generally reacts quickly to market changes.
12-Month Treasury Average (12MTA) This index is the 12 month average of the monthly average yields of U.S. Treasury securities, adjusted to a constant maturity of one year. Because this index is an annual average, it reacts slowly to market changes.
6-Month Certificate of Deposit (6-Month CD) This index is the weekly average of the secondary market interest rates paid on nationally traded 6-month certificates of deposit. This index is generally considered to react quickly to changes in the market.
Prime Rate The Prime Rate is the lowest commercial rate charged by banks on short-term loans to their most creditworthy customers. Depending on economic conditions, this index can be volatile or not move for months at a time.
11th District Cost of Funds Index (COFI) The average cost of deposits and borrowings in the Federal Home Loan Bank's 11th District, that consists of California, Arizona and Nevada. This index is slow moving due to the size of the deposits and generally lags behind market fluctuations.
Some adjustable rate mortgages have a conversion feature that would allow you to convert the loan from an adjustable rate mortgage to a fixed rate mortgage. The conversion rate is usually slightly higher than the market rate that the lender could provide you at that time by refinancing so many times it makes sense to simply refinance your adjustable rate mortgage.
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