A mortgage product has recently resurfaced that you may not have seen in many years: the adjustable-rate mortgage (ARM).

ARMs become popular when interest rates rise and homebuyers look for ways to save on interest to make homeownership more affordable. Rates are up and ARMs are back again, but it has been quite a while since we experienced this phenomenon. As REALTORS^®, we need to understand this mortgage product so we can explain it to our buyers and sellers. We should know for whom this product may be suitable. There is an area of the financing commitment contingency of the WB-11 Residential Offer to Purchase and the WB-14 Residential Condominium Offer to Purchase that needs to be completed if the buyer is applying for ARM financing, which can be confusing.

If you entered the industry within the last five years, you may have never seen this product used in your transactions. And even if you’ve been in the business for a long time, it may have been some time since you encountered this product. Due to changes in regulations, ARMs are somewhat different compared to many years ago.

ARMs are a byproduct of high interest rates of the late 1970s and early 1980s and the savings and loan crisis that followed. From 1995 to 2004, ARMs accounted for over 18% of all mortgage applications. Just prior to the mortgage crisis in the mid-2000s, the share of ARMs rose to over 34% of all mortgages. Then from 2009 to 2021, due to new regulations and low interest rates, ARMs were a very small percentage of mortgages. In 2021, when fixed-rate mortgages were at historic lows, ARMs accounted for less than 3% of mortgage applications. However, interest rates increased dramatically in 2022, and the share of adjustable-rate mortgages amplified to over 12%. This coincided with higher home prices, causing homebuyers to find new ways to afford to purchase a new home.

The latest Wisconsin housing statistic shows the median home price in Wisconsin increased 6.9% from March 2022 to March 2023 to $272,500. For someone putting 20% down, this results in an increase of $67.55 per month for the same home. However, that’s assuming interest rates are at 3.5%. With the 30-year, fixed-rate mortgage recently peaking at about 7.25%, the same house now costs $575 more per month compared to just a year ago. It is substantially for this reason that ARMs have made a comeback.

With both home prices and rates up, REALTORS^® who understand ARMs can use this to their advantage to sell more homes. The lower initial rate of an ARM allows buyers to buy a house they didn’t think they could afford. A larger mortgage equates to a more expensive home. Assuming an ARM at 6% vs. a fixed-rate mortgage at 7.25%, a buyer can afford a home that costs 14% more for the same monthly payment. Although fixed and ARM rates have recently come down a bit, the affordability factor between the two is the same.

But why would anyone want a mortgage where the rate can change, and what is an ARM? We’ll get into some specifics on how ARMs work, their advantages and disadvantages, and what kind of buyer may want an ARM. Then we’ll discuss how to write and present an offer that has an ARM financing contingency.

Buyer motivations and rates

There are several reasons a buyer may choose to use an ARM. The obvious reason is ARMs have initial interest rates that are generally lower than fixed-rate mortgages. The rate difference, and therefore monthly payment, can be substantial. The rate differential and amount of savings depends on the type of ARM as well as market conditions.

ARMs have an initial rate called the start rate. This is also known as the discounted rate or “teaser rate” since it entices a borrower to select this mortgage program even though the rate can go up.

The length of time before the initial rate can change the very first time is called the start rate period. Start rate periods vary. Longer start rate periods are riskier for lenders and therefore have higher rates.

The most common start rate periods are five, seven and 10 years. A start rate period of five years is called a five-year ARM, and a start rate period of seven years is called a seven-year ARM, and so on.

ARMs have other components like the maximum first adjustment. This is the most the interest rate can increase the very first time it adjusts. It’s often different than the maximum subsequent adjustments discussed next. The maximum first adjustment can be as low as .5% or as much as 5% or even 6%. It’s not uncommon to see seven-year and 10-year ARMs with 5% initial maximum adjustments.

Lenders qualify borrowers at the start rate for seven- and 10-year ARMs. However, it’s important to note they use the first adjustment rate with five-year ARMs due to regulations. Although the initial rate of a five-year ARM may be lower, the qualifying rate can be higher than seven- and 10-year ARMs.

Another element of ARMs is the subsequent adjustment period.

This is how often the rate adjusts after the initial adjustment and every time thereafter. The adjustment period can be every six months, every year or even every three years. The most common subsequent adjustment periods are six months and one year.

Traditionally, the subsequent adjustment period was annual, but many ARMs sold by lenders to the secondary market now have six-month subsequent adjustment periods.

Adjustment caps

The next aspect of an ARM is its subsequent adjustment cap. This is the maximum the interest rate can go up or down at each subsequent adjustment. It limits the amount the interest rate can increase or decrease every time the rate adjusts. This is essential as it protects the borrower from the rate going up too much in a short period of time. Lenders call this “payment shock” and can lead to default. The adjustment cap has the same protections for lenders when interest rates are going down. You will find that ARMs with annual adjustments often have a 2% subsequent adjustment cap, and those with six-month adjustments have a 1% subsequent adjustment cap. I’ll point out some items noteworthy to REALTORS^® on this matter later in this article.

An additional rate limitation ARMs have is the lifetime cap. The lifetime cap is the maximum rate of interest the loan can ever reach. Most ARMs have either 5% or 6% lifetime caps. This cap protects the borrower from unlimited future rates.

Lenders use an index to determine what the interest rate will adjust to at the time of the subsequent adjustments. The index is a short-term financing instrument that is out of the lender’s control. Common indices are one-year T-bills, the cost of funds index for a particular Fed district, and most recently the Secure Offer Finance Rate (SOFR). The SOFR index is now common among secondary market loans and replaced the London Interbank Offered Rate (LIBOR). A lender will use the index rate, typically 45 days prior to the adjustment date, to determine the new rate for the next adjustment period.

For the ARM to be profitable for lenders, a margin is added to the index. The margin is determined at closing and never changes. The index at the time of adjustment plus the margin determines the new rate for the next adjustment period. When adding the index and margin, the result is known as the fully indexed rate.

Benefits for homebuyers

Now that we understand how ARMs work, let’s look at some of the advantages ARMs have for homebuyers, and who may benefit from this program.

While the initial rate of an ARM is generally lower than a fixed rate, it does come with risks that the rate could increase in the future. It’s not guaranteed that the rate will go up — the rate could in fact go down — but a higher future rate is a borrower’s main concern.

Despite its risk, this may not be an issue for some borrowers. There is the possibility that rates decrease during the start rate period. This would allow the borrower to refinance into a fixed-rate loan or another ARM in the future. Rates generally have highs and lows in four- to seven-year periods. A seven-year ARM, for instance, covers that rate cycle, along with the opportunity to refinance if rates come back down. The mantra lenders use is "date the rate and marry the house."

Also, the house someone is buying may be short term due to frequent job changes or other circumstances. Most loans are paid off in under 10 years for one reason or another

Another candidate for an ARM is someone who is anticipating greater household income in the future, for instance, a partner entering or re-entering the workforce. Higher income may also be due to the likelihood of higher future wages. This would offset the potentially larger future payments if rates do go up. Also doctors in residency whose income will be greater upon completion may benefit from this program.

However, ARMs are not for everyone. A borrower with a fixed income may want a corresponding fixed-rate loan. A buyer may be buying their “forever home.” A short-term rate is not a good strategy for a long-term situation. Regardless, ARMs are more risky than fixed-rate loans and may not fit a borrower’s risk tolerance.

Contract drafting 

Now that we understand how ARMs work as well as the best candidates for this product, let’s look at how to complete and present the financing commitment contingency of the WB-11 and WB-14.

If your buyer is applying for an ARM, the financing commitment contingency of both WB forms must be completed correctly. If it does not match the loan commitment, you may provide a buyer wanting out of the contract with a solution. We never want this to be the agent’s fault.

We’ll use the WB-11 for illustration. The WB-14 is identical except for line numbers.

With ARM financing, lines 249-263 remain the same as for fixed-rate loans. What to enter on lines 266-270 is what we’re concerned with.

The check box on line 266 should be checked. The blank on line 266 is the start rate. The first blank on line 267 is the initial start rate period. For a five-year ARM, this is 60 months, and for a seven-year ARM, it’s 84 months.

The second blank is the initial maximum first adjustment discussed previously. Note that the default is 2%. However, many seven-year and 10-year ARMs have an initial maximum of 5%. It’s tempting to leave this blank since the default is often correct. In this case, however, we must know what the actual maximum first adjustment is.

The blank on line 268 is the maximum subsequent adjustment. It is not uncommon for this to be 1% if the rate adjusts every six months, and 2% if adjusted annually. Note the default is 1%. That may not be the case, and the offer would then not match the buyer’s loan commitment.

Finally, the blank on line 270 is the lifetime cap. This is the maximum the interest rate can ever reach, regardless of the index plus margin.

It is good practice to find out the specific terms of the buyer’s adjustable-rate financing directly from the lender. Buyers tend to focus on the initial rate and start rate period and are less concerned with the other terms. However, when writing an offer, those terms are important.

Final thoughts

ARMs are a great tool when interest rates are relatively high. They have not been used much of late but have made a comeback. They allow the right buyers to afford a larger loan amount, and therefore a higher home price. An adjustable-rate mortgage might be the perfect fit to help sell a listing or get your buyer into their dream home.

Rudy Ibric (NMLS 273404), BS, ABR, is a loan officer and business development manager at CIBM Bank, REALTOR^® and an adjunct mortgage instructor at Waukesha County Technical College, and assists the WRA with mortgage education. For more information, contact Ibric at 414-688-7839.