What is an Adjustable Rate Mortgage? Q & A with Todd Newpher

Building blocks that say ARM and index/margin next to a toy house on a calculator

Adjustable rate mortgages (ARMs) got a bad rap in the late aughts with the subprime mortgage housing crisis. Those mortgages had loose standards and were the result of bad business practices from a few large lenders.

The reality is ARMs have been a great option for homebuyers since the 1990s, following a period of very high interest rates in the 1980s. As many as 35% of borrowers in December 1994 applied for an ARM. Today, the level of borrowers with an ARM sits at around 12%, so it’s still a popular option. However, because of its recent history, many people are skeptical about the advantages.

We sat down with Todd Newpher, PSECU Mortgage Originator Manager to talk ARMs and shed some light on the mystery surrounding this mortgage product.

Photo of Todd Newpher

Todd Newpher, PSECU Mortgage Originator Manager

What is an ARM and how do they work?

An adjustable-rate mortgage differs from a fixed-rate mortgage in many ways. Most importantly, with a fixed-rate mortgage, the interest rate stays the same during the life of the loan. With an ARM, the interest rate changes periodically, usually in relation to an index, and payments may go up or down accordingly.

The initial rate and payment amount on an ARM will remain in effect for a limited period—ranging from just 1 month to 5 years or more. For some ARMs, the initial rate and payment can vary greatly from the rates and payments later in the loan term. Even if interest rates are stable, your rates and payments could change a lot. If lenders or brokers quote the initial rate and payment on a loan, ask them for the annual percentage rate (APR). If the APR is significantly higher than the initial rate, then it is likely that your rate and payments will be a lot higher when the loan adjusts, even if general interest rates remain the same.

With most ARMs, the interest rate and monthly payment change quarterly, semi-annually, yearly, 3 years, 5 years, 7 years or 10 years. The period between rate changes is called the adjustment period. For example, a loan with an adjustment period of 1 year is called a 1-year ARM, and the interest rate and payment can change once in a 12-month period. A loan with a 3-year adjustment period is called a 3-year ARM. You will carry the initial interest rate for the first three years before the first-rate adjustment may take place.

What are the parameters of PSECU’s ARM?

PSECU currently offers a 1-year ARM. That means the monthly payment and interest rate will be locked in for one year and will change after that adjustment period ends. After the 1st year, the interest rate will either remain the same, increase, or decrease based on the current rate environment at that time. The maximum the rate can increase in any one year is 1% and over the full term of the mortgage the rate can only increase by a maximum of 5% over the original interest rate. You can refinance out of the ARM and into a fixed rate mortgage at any time during the term of the mortgage with no pre-payment penalty. It’s important to note that while refinancing at any time is an option, it is not guaranteed and will depend on your future situation, the property value of your home, and market conditions.

What are the pros and cons of an ARM?

Lenders generally charge lower initial interest rates for ARMs than for fixed-rate mortgages. At first, this makes the ARM easier on your pocketbook than a fixed-rate mortgage for the same loan amount. Moreover, your ARM could be less expensive over a long period than a fixed-rate mortgage. For example, if interest rates remain steady or move lower. An ARM is a great option if your goal is to get the lowest possible mortgage interest rate starting out.

Against these advantages, you have to weigh the risk that an increase in interest rates would lead to higher monthly payments in the future. It’s a trade-off—you get a lower initial rate with an ARM in exchange for assuming more risk over the long run.

Here are some questions you need to consider:

  • Is my income enough—or likely to rise enough—to cover higher mortgage payments if interest rates go up?
  • Will I be taking on other sizable debts, such as a loan for a car or school tuition, in the near future?
  • How long do I plan to own this home? (If you plan to sell soon, rising interest rates may not pose the problem they do if you plan to own the house for a long time.)
  • Do I plan to make any additional payments or pay the loan off early?

Is there anyone who an ARM would not be ideal for?

The reality is that for many homebuyers who want the lower payment of an adjustable-rate loan, the added risk is often more than they can afford to take because they don't have a big income or vast savings. So, for those borrowers who have tight budgets and little savings to assist with making higher payments if rate increases, they would be better off doing a mortgage product that offers less financial risk or purchasing a less expensive home.

Is there any additional information you would give someone who is considering an ARM?

Make sure you are getting all the right information to make a well-informed decision. Lenders must give you written information on each type of ARM loan you are interested in. The information must include the terms and conditions for each loan, including information about the index and margin, how your rate will be calculated, how often your rate can change, limits on changes (or caps), an example of how high your monthly payment might go, and other ARM features such as negative amortization (what happens when you make regular payments on a loan but the amount you owe will still go up because you are not paying enough to cover the interest).

ARMs can be a useful tool to get into your dream home, but they don’t make sense for every borrower.

Benefits of a Home Loan with Us

At PSECU, you’ll find a wide variety of mortgage loan products, customized service, and experts to guide you through the mortgage application process. We offer our members very competitive rates and reduced closing costs as we do not charge our members for an appraisal, flood certification, or credit reports. PSECU also works with preferred settlement companies throughout Pennsylvania that our members can select to use to help save even more money on their closing costs. You can complete your application online, at your convenience – and if you have questions, our trained mortgage consultants are here to help. If you’re considering an ARM for purchasing a home, check out our competitive rates and get started on an application!

The content provided in this publication is for informational purposes only. Nothing stated is to be construed as financial or legal advice. Some products not offered by PSECU. PSECU does not endorse any third parties, including, but not limited to, referenced individuals, companies, organizations, products, blogs, or websites. PSECU does not warrant any advice provided by third parties. PSECU does not guarantee the accuracy or completeness of the information provided by third parties. PSECU recommends that you seek the advice of a qualified financial, tax, legal, or other professional if you have questions.