How Does an Adjustable Rate Mortgage (ARM) Work?

Published on March 18, 2017

– 5 min read

The Adjustable Rate Mortgage (“ARM”) still causes many people to squirm, but in reality, an ARM can be beneficial for you under the right circumstances.

An ARM in a Nutshell

An ARM just means your interest rate (and therefore your monthly principal and interest payment) may change after an initial fixed period.

For example, a 5/1 ARM at 3.500% interest rate means that you’ll have a 3.500% interest rate for the first 5 years (60 months), and then the rate may change up to once per year for the remaining 25 years of the 30-year loan.

Keep in mind that ARMs typically have caps to protect homeowners from crazy market and rate changes. Clara’s 5/1 ARM products have the following caps:

  • 2% Initial Cap
  • 2% Period Cap
  • 5% Lifetime Cap

These caps means your interest rate can never increase more than 2% the first year, 2% in subsequent years, and 5% total.

As an example, the worst possible scenario for a starting loan amount of $200,000, is this:
 

YearsRateLoan AmountMonthly Payment (P&I)*
1-53.500% $200,000 $898
65.500% $179,394 $1,102
77.500% $175,955 $1,319
8-308.500% $173,232 $1,431

* Monthly Payment (P&I) only includes principal and interest. Other monthly costs typically include taxes, homeowner’s insurance and sometimes mortgage insurance.
 

You always have the options to refinance, sell your home or pay off your loan early (Clara doesn’t offer loans with a prepayment penalty).

You can read more on the CFPB website.

Who should consider 5/1 and 7/1 ARMs?

If you only plan to stay in your home for a few years

You just bought your first or second home and want to move on to something bigger and better in 5 years… Guess what? The “adjustable” part of the ARM loan won’t even affect you, provided you sell your home before the rate can change!

You want to save money now and you have room in your budget

If an extra $204 per month at the beginning of Year 6 for you isn’t a huge deal, you’ll be able to enjoy lower monthly principal and interest payments for the first 5 years. ARMs generally have lower initial rates than Fixed Rate loans. So homeowners who can absorb some amount of risk for a higher monthly payment may feel comfortable.

 

Curious to learn more about how to choose between ARM vs. fixed mortgages? See our article here. If you have any questions, chat with one of our licensed Loan Specialists or see what ARM rates are available now.

Steven Fung
Steven Fung is a licensed Loan Specialist at Clara with over 17 years of experience. When he doesn’t have his mortgage hat on, he enjoys repairing old cars and working on home improvement projects.
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