A fixed-rate mortgage is fixed for the entire term of the loan, most commonly 30 years as a 30-year term will have a lower monthly payment than a 15-year term.
With an adjustable-rate mortgage, the initial rate (the rate you have at the start that is used to determine your monthly mortgage payment) is fixed for a set period of 1 to 15 years, sometimes known as the initial fixed rate period. 5 and 7 years are perhaps the most common initial fixed-rate periods. From there, the interest rate will adjust at certain set time periods. Depending on the ARM it could be every 6 months or every year.
With a 5/1 ARM, the interest rate would stay unchanged for the first 5 years of the mortgage, then adjust every year thereafter. A 7/6 ARM would have an initial rate set for 7 years and adjust every 6 months.
Okay, but adjust to what? This is where the term index comes into play. The index is one of 2 variables that will determine the new rate and thus the homebuyer’s new monthly mortgage payment. The lender will set the index to be used. There are several indexes, but common ones include the Secured Overnight Financing Rate (SOFR) and the Constant Maturity Treasury (CMT).
The index alone doesn’t tell us the new rate. For that we need to also know what the margin is. The new interest rate at the time of adjustment is the sum of the current index rate plus the margin. Typically, the margin is 2%-3% and won’t change over the life of the loan.
So, let’s walk through an example. As of mid-June 2022, interest rates for 30-year fixed-rate mortgages were around 5.75%. Let’s assume a person selected instead to do a 5/1 ARM, which around the same time had an interest rate of 4.33%. The initial rate would be 4.33% and remain fixed for the first 5 years of the loan.
After 5 years the rate will adjust. For our example, we’ll say the Index is the SOFR, mentioned above. We don’t know what the SOFR rate will be 5 years from now, but since in mid-June 2022 it was around 1.45%, for our example let’s say it will be 3% in 5 years. Let’s also assume that the margin for the 5/1 ARM was 3%. So 3% + 3% means the new interest rate for the next year will be 6%, up from the initial rate of 4.33%.
Or maybe not! This brings us to rate caps. Because a larger increase in interest rate likely would mean a significant increase in the homebuyer’s monthly payment, lenders use rate caps to limit how large of an increase can occur. There are 3 caps to know about when accepting an ARM:
- The initial adjustment cap limits the amount the rate may change at the first adjustment. A common initial adjustment cap is 2%. In our example above, using an initial rate of 4.33%, the maximum interest rate after adjustment would be 6.33%.
- The subsequent adjustment cap is a limit on how much the rate can change after the first adjustment. Again, 2% is common, but keep in mind that this cap is based on the previous interest rate, not the initial. If the first rate adjustment reached the maximum of 6.33%, at the next adjustment, if a 2% subsequent cap was in place, the maximum new interest rate would be 8.33%.
- The lifetime cap is the limit on how high the interest rate may go over the life of the loan compared to the initial rate. A common lifetime cap may be 5%, which in our example means the homebuyer’s rate will never be more than 9.33%.