Adjustable-Rate Mortgage (ARM)

An adjustable-rate mortgage is a mortgage on which the interest rate can change after closing. Regulation Z defines it at 12 CFR 1026.20(c)(1)(i) as a closed-end consumer credit transaction secured by the consumer's principal dwelling in which the annual percentage rate may increase after consummation, and the same definition governs the initial-adjustment disclosure at 1026.20(d)(1)(i). Elsewhere in the regulation the wider family is called a variable-rate transaction, which is the heading the application-stage disclosure obligations sit under at 1026.19(b).

In practice the loan has two phases. For an introductory period, commonly several years, the rate is fixed. After that it adjusts on a stated frequency for the rest of the term. CFPB's own consumer handbook explains the naming convention: in an ARM advertised as 5/1 or 5/6m, the first number tells you how long your initial interest rate lasts and the second tells you how often the rate changes after that. So a 5/6 ARM is fixed for five years and then adjusts every six months, while a 5/1 is fixed for five years and then adjusts annually. Getting that second digit backwards is the most common error in circulation about these loans.

The rate after the introductory period is the index plus the margin, and the two halves behave completely differently. CFPB states the mechanics directly. The index is an interest rate that fluctuates with general market conditions; the lender decides which index the loan will use when you apply, and that choice generally will not change after closing. The margin is the number of percentage points the lender adds to the index, it is set in the loan agreement, and it will not change after closing. Their sum is the fully indexed rate.

The margin is where the negotiation is, and virtually no consumer coverage says so. CFPB does: you should pay attention to the margin when shopping because it can vary a lot between lenders, and you can negotiate it just as you would negotiate the rate on a fixed-rate loan. Regulation Z reinforces the point from the disclosure side. 1026.19(b)(2)(iii) requires the loan program disclosure to explain how the rate and payment will be determined, including how the index is adjusted, such as by the addition of a margin, and (b)(2)(iv) requires a statement that the consumer should ask about the current margin value and current interest rate. Two borrowers on the same index with margins a full point apart will pay different rates for the next twenty-five years, and only one of them was ever told to ask.

On which index a loan uses, the honest answer is that it varies and the document says. CFPB's own handbook notes that different lenders use different indexes and gives the U.S. prime rate and the Constant Maturity Treasury rate as common examples, and points the borrower at page 2 of the Loan Estimate, where the index is shown. Anything keyed to LIBOR is stale, since U.S. dollar LIBOR has been discontinued, but the index on any particular loan is a fact about that loan rather than an industry constant.

The caps are not one number, and the Loan Estimate presents them better than the industry shorthand does. CFPB's handbook reproduces the Adjustable Interest Rate table that appears on page 2 of the Loan Estimate, and its rows are the ones to read: index plus margin, the initial interest rate, a minimum and maximum interest rate for the life of the loan, the change frequency for the first change and for subsequent changes, and limits on interest rate changes stated separately for the first change and for subsequent changes. The trade shorthand compresses those into three figures, an initial cap, a periodic cap and a lifetime cap, but the table is what the borrower actually receives. One further point from the handbook is easy to miss: generally, an ARM's interest rate is never lower than the margin, so the margin sets the floor as well as contributing to every rate above it.

Federal law fixes how much warning a borrower gets, and it is more than most people assume. For the first adjustment, 12 CFR 1026.20(d) requires the disclosure to be provided at least 210 but no more than 240 days before the first payment at the adjusted level is due, as a separate document. That is roughly seven to eight months. For subsequent adjustments that change the payment, 1026.20(c)(2) requires disclosure at least 60 but no more than 120 days ahead, shortened to at least 25 but no more than 120 days for ARMs with uniformly scheduled adjustments occurring every 60 days or more frequently. Where the first payment at the adjusted level falls within 210 days of closing, the initial disclosure is given at closing instead. So a borrower has most of a year to prepare for the first reset, and can use it to budget, to sell, or to shop for a refinance.

A note on negative amortization, because both common statements about it are wrong. It is not banned in general. Regulation Z at 1026.19(b)(2)(vii) still requires any negative amortization feature to be disclosed in the loan program disclosure, and the statutory prohibition at 15 USC 1639(f) reaches high-cost mortgages rather than all loans. What is true is that a borrower will not meet it in a mainstream conforming loan today. Read the disclosure rather than assuming either way.

The decision itself is a matter of matching the loan to the holding period and to what happens if the rate reaches its maximum. CFPB's own caution is the right one to repeat: do not assume you will be able to sell the home or refinance before the rate changes, because property values and personal circumstances both move, and if the payment at the maximum rate is not affordable on today's income, that is information about the loan rather than about the future.

At application the lender provides a loan program disclosure for each adjustable program the borrower is interested in, along with the CFPB's Consumer Handbook on Adjustable Rate Mortgages. The Loan Estimate then carries the Adjustable Interest Rate table with the specific index, margin, initial rate, caps, minimum and maximum rate, and change frequency. The initial rate runs for the introductory period. At each adjustment the servicer computes the index plus the margin, applies the caps, and sends the required advance notice.

A hypothetical example of how the caps bite. Wren takes a 5/6 ARM. The initial rate is 5.50%, the margin is 2.75%, the limit on the first change is 2 percentage points, the limit on each subsequent change is 1 percentage point, and the maximum rate over the life of the loan is 10.50%.

At the first adjustment, five years in, the index stands at 4.00%. The fully indexed rate is the index plus the margin, or 6.75% (4.00 + 2.75). The first-change limit would have allowed anything up to 7.50% (5.50 + 2), so the cap is not binding and Wren's new rate is 6.75%.

Six months later the index has moved to 5.50%. The fully indexed rate is now 8.25% (5.50 + 2.75), but the subsequent-change limit is one point, so the rate can only rise to 7.75% (6.75 + 1). Wren pays 7.75% while the market says 8.25%, and whether the untaken half point carries forward into the next adjustment depends on whether the loan has an interest rate carryover feature, which the program disclosure has to state.

Two things are worth reading off that example. The caps limit the speed of the increase rather than its destination, so a sustained rise reaches the lifetime maximum of 10.50% in stages. And the margin of 2.75% is in every one of those rates, which is why a borrower who negotiated a lower margin at the outset pays less at every adjustment for the rest of the loan.

Pros

• The introductory rate is usually below the fixed rate available at the same time, which lowers the payment during the initial period.
• Suited to a borrower with a genuinely short expected holding period, where paying for thirty years of rate certainty buys something they will not use.
• If market rates fall, the rate adjusts downward without the closing costs of a refinance, subject to any floor.
• The warning is generous and legally fixed. Seven to eight months before the first reset, and two to four months before later ones.

Cons

• The borrower carries the interest rate risk after the introductory period, and the payment can rise substantially.
• Caps limit how fast the rate can climb, not how high it can go, so the lifetime maximum is the number to test against a household budget.
• Assuming you will sell or refinance before the reset is a plan that depends on property values, credit and income all cooperating.
• The loan is genuinely more complex, with an index, a margin, three separate caps, an adjustment frequency and possible carryover, all of which have to be read.
• The margin is fixed for the life of the loan, so a poorly negotiated margin is permanent in a way an index level never is.