An adjustable-rate mortgage (ARM) is a type of home loan where the interest rate can change over time, unlike a fixed-rate mortgage, which maintains the same interest rate throughout the loan term. ARMs often start with a lower interest rate than fixed-rate mortgages, making them potentially beneficial if you plan to sell your home within a few years, expect your income to rise, or if current fixed rates are particularly high.
ARMs consist of four main components: an index, a margin, an interest rate cap structure, and an initial fixed-rate period. After this initial period, the interest rate is recalculated by adding a set margin to the index value. Lenders disclose the margin at the time of application, and since margins vary between lenders, it’s wise to compare offers. The interest rate will adjust based on movements in the chosen index.
For FHA-insured ARMs, acceptable indices include the Constant Maturity Treasury (CMT)—a weekly average yield of one-year U.S. Treasury securities—and the 1-year London Interbank Offered Rate (LIBOR). Interest rate caps limit how much your rate can increase or decrease, providing protection against large fluctuations.
There are two types of caps:
• Lifetime cap: Sets the highest and lowest possible interest rate over the loan’s term.
• Annual cap: Limits how much the rate can change in a single year.
FHA offers a standard 1-year ARM and four hybrid ARM options. These hybrids feature a fixed interest rate for an initial period of 3, 5, 7, or 10 years, after which the rate adjusts annually.
Here are the cap structures for each:
• 1 and 3 year ARMs: Interest rates can rise by up to 1% annually, with a lifetime cap of 5%.
• 5-year ARMs: Can increase either by 1% annually with a 5% lifetime cap, or by 2% annually with a 6% lifetime cap.
• 7 and 10 year ARMs: Interest rates may increase by up to 2% each year, with a 6% cap over the life of the loan.