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 the “adjustable” label 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.

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.

1. Index: A benchmark interest rate that fluctuates based on market conditions, determining how the ARM’s rate adjusts over time.
2. Margin: A fixed percentage that gets added to the index to calculate the total interest rate after the initial period (mentioned below).
3. Interest Rate Caps: Limits on how much the interest rate can increase from one adjustment period to the next and also over the life of the loan.
4. Initial Phase: A fixed-rate phase that occurs at the start of the loan, during which the interest rate does not change.

An ARM loan starts with an initial fixed interest rate period. After this, the interest rate adjusts periodically based on an index plus a margin.

Meanwhile, the interest rate caps limit how much the rate can change at each adjustment and over the loan’s lifetime, protecting the borrower from drastic increases.

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 a standard fixed mortgage.

But at some point, the rate will begin to adjust, following the up or down movements of a certain benchmark.

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 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 that are beyond your control. So there’s more uncertainty involved when using an ARM loan in the Bay Area.

Some home buyers use ARMs 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. That’s one way to play it.

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 an 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.

A Closer Look: The 5/1 ARM Loan Option

There are different versions of the adjustable-rate mortgage. But the 5/1 ARM loan is arguably the most popular. So let’s take a close look at how it works.

This type of mortgage starts off with a fixed interest rate for the first five years. That’s what the number ‘5’ designates in the label.

During this initial phase, the loan essentially behaves like a fixed-rate product. The interest rate stays the same. So there is some degree of stability with these products, at least initially.

After the first five years, however, the interest rate will begin to adjust or change.

The rate changes annually, or every one year (until the home is either sold or refinanced, or the loan is paid off). That’s what the number ‘1’ designates in the label.

The 5-year adjustable-rate mortgage isn’t the only game in town. 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. For example, a 7/1 ARM loan will have a fixed interest rate for the first seven years of the term, and then adjust annually thereafter.

Five Things to Take Away From All of This

We’ve covered a lot of information here, because we believe Bay Area home buyers deserve to be well informed. Here are the most important points to take away from this guide:

1. An adjustable-rate mortgage (ARM) has an interest rate that changes over time, unlike a fixed-rate loan.
2. Most ARMs start with a fixed interest rate for a set period before adjusting based on a benchmark index plus a margin.
3. Interest rate caps limit how much the rate can increase per adjustment and over the life of the loan, providing some protection for borrowers.
4. Hybrid ARMs, such as the 5/1 ARM, offer an initial fixed-rate period (e.g., five years) before switching to annual adjustments.
5. ARMs can help Bay Area buyers secure lower initial payments but come with the risk of rising rates in the future.