Adjustable-rate mortgages (ARMs) call for periodic adjustments to both the interest rate and the dollar amount of scheduled payments.

You’ll find a plethora of ARM types, each providing a different route to amortization through a graduated payment schedule. Let’s review common ARMs by surveying the types most popular during the Millennium Boom.

The Hybrid ARM is a fusion of an FRM and an ARM in which the interest rate is fixed during the initial loan term, then adjusts periodically afterward.

One of the most common types is the 5/1 ARM. With this type of loan, the interest rate is fixed for the first five years of the loan, typically at a low teaser rate. Then the rate adjusts once a year after that initial period expires.

Similar hybrid ARMs are intended for those with less-than-perfect credit. The initial rate is short to allow the borrower to qualify for a loan, with the intent of improving their credit and refinancing out after the initial fixed rate.

Hybrid ARMs can meet the requirements for qualified mortgages, meaning it’s one of the only ARM types to survive the ability-to-repay requirements.

The remaining ARM loans discussed in this video have been relegated back to their rightful place as niche products for extremely well-qualified borrowers.

With an interest-only ARM, the borrower’s monthly payments are applied only to the interest due on the loan, not the principal. After the interest-only period expires, the borrower’s monthly payments are adjusted to include both interest and principal.

But because the borrower does not make any principal payments during the initial period, the principal payments are amortized over a shorter period of time. The longer the interest-only period, the greater the payments will be when the loan recasts.

In an option ARM, the borrower may choose from several different payment options each month, including:

  • principal and interest under a traditional amortization schedule for the full term of the loan,
  • interest only, or
  • a minimum amount, usually less than the interest due.

These loans also typically begin with a very low teaser rate, though only for a month or so before increasing regularly every month.

These ARMs have a high potential for negative amortization. This is because choosing the minimum amount adds the unpaid interest onto the principal. The loan recasts after a certain number of years according to the new principal balance—easily exceeding the original amount.

Some ARMs have built-in terms allowing the ARM to be converted to an FRM during the loan term. These are known as Conversion ARMs.

Conversion is not mandatory, and there are several drawbacks to consider:

  • the interest rate upon conversion may be higher than the average FRM rate offered at the time
  • the lender may charge a higher interest rate during the ARM portion of the loan than for other loans without conversion features; and
  • the lender may charge a fee for the conversion.

While the Millennium Boom was the ARM’s heyday, rising interest rates are once again tempting homebuyers to overextend their finances.