An adjustable-rate mortgage, or ARM, is a home loan with an interest rate that can change periodically. This means that the monthly payments can go up or down. Generally, the initial interest rate is lower than that of a comparable fixed-rate mortgage2. After that period ends, interest rates — and your monthly payments — can go lower or higher.
Interest rates are unpredictable, though in recent decades they’ve tended to trend up and down over multi-year cycles. The U.S. has been in an upward interest rate trend since about 2016, but the five years before that rates were low and flat.
An adjustable rate mortgage is a loan that bases its interest rate2 on an index. The index is typically the Libor rate2, the fed funds rate2, or the one-year Treasury bill2. An ARM is also known as an adjustable rate loan, variable rate mortgage, or variable rate loan.
Each lender2 decides how many points it will add to the index rate. It's typically several percentage points. For example, if the Libor rate is 0.5%, the ARM rate could be anywhere from 2.5% to 3.5%. Most lenders will keep the rate at that advertised rate for a certain period. Then the rate rises at regular intervals. This is known as a reset. It depends on the terms of the loan. It can occur monthly, quarterly, annually, every three years or five years, depending on the type of loan you get. You've got to read the small print carefully to determine if you will be able to pay the higher interest rate.
The advantage of adjustable rate mortgages is that the rate is lower than for fixed-rate mortgages3. Those rates are tied to the 10-year Treasury note2. That means you can buy a bigger house for less. That's particularly attractive to first-time homebuyers and others with moderate incomes.
The big disadvantage is that your monthly payment can skyrocket if interest rates rise. Many people are surprised when the interest rate resets, even though it's in the contract. If your income hasn't gone up, then you may no longer be able to afford your home and could lose it.
Adjustable rate mortgages became popular in 2004. That's when the Federal Reserve2 began raising the fed funds rate2. Demand for conventional loans fell as interest rates rose. Banks created adjustable rate mortgages to make monthly payments lower.
In 2004, bankers got creative with new types of loans to entice potential homeowners. Here are some examples of the most popular.
Interest-only loans2. They have the lowest rates. Your monthly payment just goes toward interest, and not any of the principle, for the first three to five years. After that, you start making higher payments to cover the principle. Or, you might be required to make a large balloon payment.
If you are aware of how they work, these loans can be very advantageous. If you can afford it, any extra payment goes directly toward the principle. If you are disciplined about making these payments, you can actually pay more against the principle. That way you will gain higher equity in the home than with a conventional mortgage. These loans are dangerous if you aren't prepared for the adjustment or the balloon payment. They also have all the same disadvantages of any adjustable-rate mortgage.
Option ARMs. They allow borrowers to choose how much to pay each month. They start with "teaser" rates of about 1%–2%. These can reset to a higher, even after the first payment. Most (80%) option ARM borrowers make only the minimum payment each month. The rest gets added to the balance of the mortgage, just like negative amortization loans2.
Borrowers think payments are fixed for five years. If the unpaid mortgage balance grows to 110% or 125% of the original value, the loan automatically resets. It can result in a payment that's three times the original amount. Steep penalties prevent borrowers from refinancing. As a result, most borrowers simply fall deeper into debt. Once the house is worth less than the mortgage, or the borrower loses a job, they foreclose3.
These loans were a huge driver behind the subprime mortgage crisis2. Although only 2% of all home loans were option ARMS, they were worth $300 billion. Most of them defaulted. At least 60% were in California, where home prices fell 30-40%. This disqualified them from taking advantage of home loan modification programs2 like MakingHomesAffordable. (Source: "Toxic Mortgages3," Center for Responsible Lending, November 5, 2007. "Nightmare Mortgages," Businessweek, September 11, 2006.)