An Adjustable-Rate Mortgage Could Have Features That Harm You
When considering mortgage options, you might encounter a choice between a fixed-rate mortgage and an adjustable-rate mortgage (ARM). While fixed-rate mortgages offer the security of unchanging payments for 10, 15, 20, 25, or 30-year terms, adjustable-rate mortgages have several variables and come in many different flavors.
In fact, there are more than 100 different varieties.
Unfortunately, many of these ARM variations weren’t designed with your best interests in mind. Instead, they often function as investment products with built-in advantages for lenders that most borrowers don’t know to ask about.
Here’s everything you need to know about ARMs.
What Is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage is a home loan where the interest rate changes periodically after an initial fixed period. Unlike fixed-rate mortgages that maintain the same interest rate throughout the loan term, ARMs feature two distinct phases: a fixed introductory period and an adjustment period when rates can fluctuate.
The introductory period, often called a “teaser rate,” typically lasts for 1, 3, 5, 7, or 10 years. During this time, the interest rate remains constant and is usually lower than what you’d pay on a comparable fixed-rate mortgage.
How ARM Teaser Rates Work
The teaser rate should offer a compelling advantage over a fixed-rate mortgage during the introductory period. The mortgage is still amortized over 30 years, but the remaining period after the teaser rate expires becomes the adjustment period. Some lenders refer to ARMs as “hybrid” mortgages, attempting to blend the fixed teaser rate with the adjustable period.
However, since the adjustment period contains the greatest risk and represents the majority of the loan’s repayment period, this terminology can be misleading.
Adjustable-Rate Mortgage Components: Index, Margin, and Caps
Once the teaser rate period ends, your mortgage rate becomes “detached” from its original basis. The index becomes the new driving force behind your interest rate, and that presents a significant amount of risk to you if you’re still making minimum monthly payments.
The Index: Your Rate’s Foundation
An index is a benchmark interest rate that fluctuates with general market conditions. There are many indices an ARM could use as a basis, and some are more volatile than others.
Common indices include:
- The Prime Rate: Used by the Federal Reserve, this is the interest rate that commercial banks often charge their most creditworthy clients.
- SOFR: The Secured Overnight Financing Rate is a transaction-based rate based on the U.S. repurchase agreement market (the market in which borrowers pledge securities as collateral, promising to buy them back later).
- MTA: The Monthly Treasury Average Index uses a moving average calculation that can sometimes hedge against rising interest rates.
- CMT: The Constant Maturity Treasury rate arm index reflects the average yield on U.S. Treasury securities.
There are many other indices for lenders to choose from. If you move forward with an ARM, it’s important to understand what index it uses and how it works.
The Margin: The Lender’s Profit Layer
The margin is a percentage point spread that lenders add to the index rate, and it has stayed close to 2.75% over the last decade.
This represents the lender’s profit and remains constant throughout the loan. Your new interest rate after the teaser period is calculated as: Index + Margin = Fully Indexed Rate.
Before signing any ARM agreement, calculate this fully indexed rate and compare it to your teaser rate.
ARM Interest Rate Caps: Your Protection Against Rate Spikes
Interest rate caps limit how much your rate can increase, providing some protection from dramatic payment increases. Modern adjustable-rate mortgages typically feature three types of caps, expressed as three numbers (such as 5/2/5).
- The initial adjustment cap limits how much your rate can increase during the first adjustment after the teaser period ends. This cap commonly ranges from 2% to 5%, but some ARMs have initial caps as high as 6%, meaning a 3.5% teaser rate could jump to 9.5% in a single adjustment.
- The periodic adjustment cap limits rate increases for subsequent adjustments, typically 1% to 2% per adjustment period.
- The lifetime cap sets the maximum total increase over the loan’s entire term, commonly 5% to 6% above the initial rate.
According to a statement from the Consumer Financial Protection Bureau, borrowers should “ask the lender to calculate the highest payment you may ever have to pay on the loan you are considering.”
This information should be available on the lender’s required disclosure documents.
The Reality of ARM Rate Increases
Many borrowers underestimate the likelihood of significant rate increases. Lenders often describe worst-case scenarios as “unlikely”. However, the mortgage contract mechanically dictates how rates reset based on index movements. When you add the margin to current index levels, substantial rate increases are not just possible but probable.
Consider this example: If you have a 5/2/5 ARM with a 3.5% initial rate, 2.75% margin, and the index rises to 5%, your rate resets to 7.75%: the 5% index plus the 2.75% margin. A monthly payment that started at $2,173 would rise to about $3,280.
Types of Adjustable-Rate Mortgage Structures
An adjustable-rate mortgage can come in a variety of forms, but there are three main structures:
- Hybrid ARMs feature an initial fixed-rate period followed by periodic adjustments. A 5/1 ARM has a fixed rate for five years, then adjusts annually.
- Interest-Only ARMs allow borrowers to pay only interest during the initial period, typically 3-10 years. After this period expires, payments must cover both principal and interest, resulting in higher monthly payments.
- Payment-option ARMs offer multiple payment choices, including minimum payments that may not cover the interest. This can lead to negative amortization, where your loan balance increases over time.
HELOCs: The Most Common ARM
Home Equity Lines of Credit (HELOCs) are the most prevalent form of adjustable-rate lending in the country. Despite arguments that HELOCs aren’t mortgages, they function as secured debt against your home with foreclosure rights.
HELOCs typically feature interest rate caps as high as 19.99% and mandatory payment increases that can triple monthly payments after 10 years.
HELOCs often start with attractive teaser rates during an interest-only draw period, typically lasting 10 years. After this period, borrowers must begin paying principal and interest. Often, this causes dramatic payment increases.
Evaluating the Risks and Rewards of an Adjustable-Rate Mortgage
ARMs can benefit borrowers who plan to sell or refinance before the adjustment period, expect interest rates to decline, need lower initial payments to qualify for larger loans, or have fluctuating income.
However, ARMs pose greater risks for most standard borrowers. This includes homebuyers who plan to stay long-term, have fixed incomes that won’t grow with potential rate increases, and those who cannot afford higher payments if rates rise.
Many borrowers choose to stay away from an adjustable-rate mortgage simply because they prefer predictable payments each month, and this is as good a reason to go with a standard loan as any. If you have a family and are on a fixed budget each month, attempting to pay off an ARM after the adjustment period can make it difficult to plan for the future.
Consumer Protections and Regulations
Lenders are required to provide rate adjustment notices 60-240 days before changes take effect and assess borrowers’ ability to repay at the fully indexed rate.
Massachusetts provides additional protections for first-time homebuyers considering a subprime adjustable-rate mortgage. For example, General Laws Chapter 184, Section 17B½ requires written affirmation from borrowers opting for variable-rate subprime loans, in-person counseling from approved nonprofit organizations, and completion of approved counseling programs.
The Massachusetts Homestead Act now protects up to $1 million in home equity from creditors.
Were You Given a Choice or Steered into an ARM?
A colleague once asked me, “Who would take an adjustable-rate mortgage in this market?”
“Everyone,” I replied, “who isn’t given a choice.”
Before choosing an ARM, request the current fully indexed rate calculation and historical data on your loan’s index performance. Ask for the maximum possible payment under all cap scenarios and detailed explanations of fees and terms.
Most importantly, it should be a glaring red flag if a lender does any of the following when offering you an adjustable-rate mortgage:
- Emphasizing only the teaser rate without explaining adjustments
- Describing rate increases as “unlikely”
- Neglecting or refusing to offer fixed-rate alternatives
- Rushing you through documentation
These are worst-case scenarios, but they are informed by history. A lender may intentionally hide the worst aspects of an adjustable-rate mortgage and steer the borrower to take out a loan that will eventually hurt them.
This type of dishonest lending was a big contributor to the 2008 housing crash. Lending standards have become stronger since then, but it never hurts to be prepared.
Talk to an Expert Before Signing on the Dotted Line
The decision between an adjustable-rate mortgage and a fixed-rate loan depends on your financial situation, risk tolerance, and homeownership timeline. While ARMs can provide initial savings and increased purchasing power, they also carry the risk of significant payment increases over time.
It is our perspective that the majority of homebuyers will be better served by a fixed-rate mortgage, unless they meet very specific financial criteria. If you’re considering an ARM, we suggest working with an independent mortgage broker. They can assess your entire financial picture and advise you on offers from multiple lenders.
Remember that your home is likely your largest financial investment. Taking time to fully understand your mortgage terms can help protect this investment.
Contact us today to start a conversation about your future.
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