When you get a mortgage, you can choose a fixed-rate or adjustable-rate mortgage, known as an ARM. While fixed-rate mortgages keep the same interest rate for the life of the loan, adjustable-rate mortgages have fluctuating rates.
What is an adjustable-rate mortgage?
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.
See how mortgage rates compare between different loan types.
The most popular adjustable-rate mortgage is the 5/1 ARM:
The 5/1 ARM’s introductory rate lasts for five years. (That’s the “5” in 5/1.)
- The 5/1 ARM’s introductory rate lasts for five years. (That’s the “5” in 5/1.)
- After that, the interest rate can change every year. (That’s the “1” in 5/1.)
Adjustable rate mortgages follow rate indexes and margins
After the fixed-rate period ends, the interest rate on an adjustable-rate mortgage moves up and down based on the index it is tied to. The index is an interest rate set by market forces and published by a neutral party. There are many indexes, and the loan paperwork identifies which index a particular adjustable-rate mortgage follows.
To set the ARM rate, the lender takes the index rate and adds an agreed-upon number of percentage points, called the margin. The index rate can change, but the margin does not.
For example, if the index is 1.25 percent and the margin is 3 percentage points, they are added together for an interest rate of 4.25 percent. If, a year later, the index is 1.5 percent, then the interest rate on your loan will rise to 4.5 percent.
Major indexes for adjustable-rate mortgages
Most adjustable-rate mortgage rates are tied to the performance of one of three major indexes.
- Weekly constant maturity yield on one-year Treasury bill. The yield debt securities issued by the U.S. Treasury are paying, as tracked by the Federal Reserve Board.
- 11th District cost of funds index (COFI). The interest financial institutions in the western U.S. are paying on deposits they hold.
- London Interbank Offered Rate (Libor). The rate most international banks are charging each other on large loans. Libor will be phased out by the end of 2021.
Sky’s not the limit on rates
You’re insulated from possible steep year-to-year increases in monthly payments because ARMs come with caps limiting the amount by which rates and payments can change.
Caps come in several forms:
- A periodic rate cap limits how much the interest rate can change from one year to the next.
- A lifetime rate cap limits how much the interest rate can rise over the life of the loan.
- A payment cap limits the amount the monthly payment can rise over the life of the loan in dollars, rather than how much the rate can change in percentage points.