The Adjustable-Rate Mortgage (ARM): A Guide for Bay Area Borrowers

Some Bay Area home buyers use the adjustable-rate mortgage (ARM) loan to finance their purchases. These loans have unique features that are useful in some situations but less appropriate in others.

These mortgages are given their “adjustable” labels to differentiate them from the more popular fixed-rate loans. They are commonly referred to as ARM loans for short, and they come in several varieties.

Here’s what you should know about using an adjustable mortgage to buy a home in the San Francisco Bay Area.

Adjustable-Rate Mortgages Explained

So what is an adjustable-rate mortgage exactly? An ARM is a home loan with an interest rate that fluctuates along with the up or down movements of a certain benchmark or “index.” Because the interest rate can change over time, the monthly payments can change as well.

This is what separates the adjustable-rate mortgages from their fixed-rate counterparts. A “fixed” home loan carries the same interest rate for the entire financing term, even if it’s 30 years.

There are four main components of an adjustable mortgage: (1) an index, (2) a margin, (3) interest rate caps, and (4) the initial interest rate period. When the initial period expires, the new interest rate will be determined by adding a “margin” to the index.

According to the Federal Reserve’s Consumer Handbook on Adjustable-Rate Mortgages:

To set the interest rate on an ARM, lenders add a few percentage points to the index rate, called the margin. The amount of the margin may differ from one lender to another, but it is usually constant over the life of the loan.

‘Hybrid’ ARM Loans: A Bay Area Financing Option

Most adjustable-rate mortgages in the Bay Area start off with a fixed rate of interest, for a certain period of time. These are commonly referred to as “hybrid” ARMs, because they combine the features of two different loan products — fixed and adjustable.

During this initial phase, the interest rates are typically lower than they are for fixed mortgages. This is what makes the ARM loan appealing to some Bay Area home buyers. They start off with a lower rate, giving borrowers a way to reduce their monthly payments. But at some point, the rate will begin to adjust, following the up or down movements of a certain benchmark.

The 5/1 ARM loan is a common type of adjustable-rate mortgage here in the San Francisco Bay Area. As the numbers imply, this type of loan starts off with a fixed interest rate for the first 5 years. After that, the rate will adjust annually, or every 1 year.

Adjustable-rate mortgages come in other “flavors” as well. Other popular hybrid ARMs include the 3/1, the 7/1, and the 10/1 adjustable mortgages. With all of these products, the first number indicates the length of the fixed-rate period. The second number (the 1) indicates the number of years between adjustments, after the fixed period expires.

For example, a 7/1 ARM loan will have a fixed interest rate for the first seven years of the term. After that, the rate will begin to adjust every year (annually).

Pros and Cons, and Why People Use Them

The upside to using an ARM loan in the Bay Area is that you could secure a lower mortgage rate, when compared to a fixed mortgage. This can be a potential money-saver, at least during the initial fixed phase. That’s an important consideration in an expensive real estate market like ours.

The downside is that your mortgage rate (and monthly payments) could potentially rise over time, due to factors beyond your control. So there’s more uncertainty involved, when using a Bay Area adjustable-rate mortgage.

Some home buyers use ARM loans as part of a short-term, money-saving strategy. They choose the adjustable mortgage to secure a lower interest rate, and then sell or refinance the home before the rate starts adjusting. So that’s one way to play it.

Related: Mortgage options for first-time buyers

Most ARM Loans Have Caps

There are usually limits to how much the interest rate can change from one adjustment to the next, and also over the life of the loan. These are known as “caps.”

The caps on a Bay Area adjustable-rate mortgage give you, the borrower, a certain level of protection from extreme rate hikes. So it’s an important topic to understand.

There are different types of caps associated with ARM loans in the Bay Area:

• Initial Adjustment Rate Cap – As the name implies, this puts a limit on how much the interest rate can rise during the first adjustment period. This cap can be expressed as a percentage. For instance, it might limit the first adjusted rate to being no more than 2% or 3% higher than the initial rate.
• Rate Adjustment Cap – This limits the amount that the rate can increase during any given adjustment, after the first adjustment.
• Lifetime Cap – This cap places a limit on how much the interest rate can increase over the full life or term of the loan, hence the “lifetime” designation.

Caps remove some of the uncertainty associated with adjustable-rate mortgages. They give you a sense of where the ceiling might be, from one phase to the next.

Have mortgage questions? Located in the Bay Area, Bridgepoint Funding has been helping home buyers and homeowners for nearly 20 years. We offer a broad range of home loan options, including both fixed and adjustable mortgages. Please contact us if you have questions or need financing.