How Adjustable-Rate Mortgages (ARMs) Affect Amortization

What is an ARM?

An adjustable-rate mortgage (ARM) is a home loan with an interest rate that can change over time. Unlike a fixed-rate mortgage, where the interest rate remains the same for the entire loan term, an ARM typically starts with a fixed-rate period for a certain number of years, after which the rate adjusts periodically, usually once per year.

Common ARM types are named with two numbers: the first indicates the length of the initial fixed-rate period in years, and the second indicates how often the rate adjusts after that. For example, a 5/1 ARM has a five-year fixed period followed by annual adjustments. Other common structures include 3/1, 7/1, and 10/1 ARMs.

Because the initial fixed period often offers a lower interest rate than a comparable fixed-rate mortgage, ARMs can be attractive to borrowers who plan to sell or refinance before the first adjustment.

Sources: Consumer Financial Protection Bureau, HSH.com, PennyMac

How Rate Adjustments Work

After the initial fixed period, the ARM interest rate is determined by adding two components: an index and a margin. The index is an interest rate that fluctuates with general market conditions, such as a benchmark rate specified in the loan documents. The margin is a fixed number of percentage points added to the index, set by the lender in the loan agreement, and it does not change after closing.

The fully indexed rate equals the margin plus the index, subject to any rate caps. When the index moves, your rate and monthly payment can go up or down accordingly, which introduces future risk that fixed-rate loans do not.

The specific index and margin are chosen at closing, and while the index can change, the lender cannot change the chosen index or the margin.

Sources: Consumer Financial Protection Bureau

How ARMs Amortize

Like a fixed-rate mortgage, a fully amortizing ARM is paid off over a set term, typically 30 years. During the initial fixed-rate period, your monthly payment is calculated using the standard amortization formula: M = P × (R(1+R)^T)/((1+R)^T-1) , where M is the monthly payment, P is the principal, R is the monthly interest rate, and T is the number of payments. This ensures that the loan is fully paid off by the end of the term.

When the interest rate adjusts, the monthly payment is recalculated based on the new rate and the remaining principal and term. This new payment is designed to ensure the loan is still fully amortized by the end of the original term, assuming the new rate stays constant for the remainder of the loan.

Because the rate can change, the amortization schedule is not fixed. Each adjustment period may result in a different payment amount, which means the proportion of principal and interest in each payment will shift as rates change.

Sources: Mortgage Research Center, LLC, HSH.com

Example: Fixed vs Adjustable Rate Schedule

To illustrate how rate changes affect amortization, consider a hypothetical $200,000 mortgage with a 30-year term. If the initial fixed rate on a 5/1 ARM is 3.5%, the initial monthly payment for principal and interest would be approximately $898. After the first five years, the principal balance would be about $179,194 (this is an example, actual numbers vary). If the rate then adjusts to 5.5%, the remaining term of 25 years would result in a new monthly payment of approximately $1,098 (hypothetical). This shows how the payment increases when the rate rises, and the amortization schedule reflects that change by reallocating a larger portion of the payment to interest at the start of the new period.

In contrast, a 30-year fixed-rate mortgage starting at 4.0% would have a constant monthly payment of approximately $955 for the entire loan term, with a predictable amortization schedule. The ARM's payment can vary, while the fixed-rate loan's payment remains stable.

Sources: HSH.com

Caps and Their Effect on Payments

ARMs typically include rate caps that limit how much the interest rate can change at each adjustment and over the life of the loan. These caps are consumer protections that help prevent dramatic rate spikes from causing unaffordable payment increases. However, the specific cap levels vary widely by loan and are disclosed in the loan agreement.

Without caps, an ARM payment could increase dramatically if the index jumped sharply. Caps mitigate this risk by limiting the maximum rate increase at each adjustment and over the entire loan term, but even with caps, payments can still rise significantly over time.

Borrowers should be aware that while caps provide protection, they do not guarantee payment stability. It's important to review the specific cap structure in your loan documents to understand your potential payment changes.

Sources: Consumer Financial Protection Bureau, HSH.com

Should You Choose an ARM?

Choosing between an ARM and a fixed-rate mortgage depends on your financial situation and how long you plan to stay in the home. ARMs often offer lower initial rates, which can be beneficial if you expect to sell or refinance before the first rate adjustment. However, after the initial period, your rate and payment can adjust upward, potentially increasing your monthly costs.

If you prefer predictable payments and plan to keep the loan for many years, a fixed-rate mortgage may be more suitable. There is no one-size-fits-all answer, and it is important to compare the terms, including caps and adjustment frequency, before deciding.

Sources: Consumer Financial Protection Bureau, HSH.com