What Is an Adjustable-Rate Mortgage (ARM)?

The term adjustable-rate mortgage (ARM) refers to a home loan with a variable interest rate. With an ARM, the initial interest rate is fixed for a period of time. After that, the interest rate applied on the outstanding balance resets periodically, at yearly or even monthly intervals.

ARMs are also called variable-rate mortgages or floating mortgages. The interest rate for ARMs is reset based on a benchmark or index, plus an additional spread called an ARM margin. The typical index that is used in ARMs has been the London Interbank Offered Rate (LIBOR).

Understanding Adjustable-Rate Mortgages (ARMs)

Mortgages allow homeowners to finance the purchase of a home or other piece of property. When you get a mortgage, you’ll need to repay the borrowed sum over a set number of years as well as pay the lender something extra to compensate them for their troubles and the likelihood that inflation will erode the value of the balance by the time the funds are reimbursed.

In most cases, you can choose the type of mortgage loan that best suits your needs. A fixed-rate mortgage comes with a fixed interest rate for the entirety of the loan. As such, your payments remain the same. An ARM, where the rate fluctuates based on market conditions. This means that you benefit from falling rates and also run the risk if rates increase.

There are two different periods to an ARM. One is the fixed period and the other is the adjusted period. Here’s how the two differ:

• Fixed Period: The interest rate doesn’t change during this period. It can range anywhere between the first five, seven, or 10 years of the loan. This is commonly known as the intro or teaser rate.
• Adjusted Period: This is the point at which the rate changes. Changes are made during this period based on the underlying benchmark, which fluctuates based on market conditions.

Another key characteristic of ARMs is whether they are conforming or nonconforming loans. Conforming loans are those that meet the standards of government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. They are packaged and sold off on the secondary market to investors. Nonconforming loans, on the other hand, aren’t up to the standards of these entities and aren’t sold as investments.

Rates are capped on ARMs. This means that there are limits on the highest possible rate a borrower must pay. Keep in mind, though, that your credit score plays an important role in determining how much you’ll pay. So, the better your score, the lower your rate.

Types of ARMs

ARMs generally come in three forms: Hybrid, interest-only (IO), and payment option. Here’s a quick breakdown of each.

Hybrid ARM

Hybrid ARMs offer a mix of a fixed- and adjustable-rate period. With this type of loan, the interest rate will be fixed at the beginning and then begin to float at a predetermined time.

This information is typically expressed in two numbers. In most cases, the first number indicates the length of time that the fixed rate is applied to the loan, while the second refers to the duration or adjustment frequency of the variable rate.

For example, a 2/28 ARM features a fixed rate for two years followed by a floating rate for the remaining 28 years. In comparison, a 5/1 ARM has a fixed rate for the first five years, followed by a variable rate that adjusts every year (as indicated by the number one after the slash). Likewise, a 5/5 ARM would start with a fixed rate for five years and then adjust every five years.

Interest-Only (I-O) ARM

It’s also possible to secure an interest-only (I-O) ARM, which essentially would mean only paying interest on the mortgage for a specific time frame—typically three to 10 years. Once this period expires, you are then required to pay both interest and the principal on the loan.

These types of plans appeal to those keen to spend less on their mortgage in the first few years so that they can free up funds for something else, such as purchasing furniture for their new home. Of course, this advantage comes at a cost: The longer the I-O period, the higher your payments will be when it ends.

Payment-Option ARM

A payment-option ARM is, as the name implies, an ARM with several payment options. These options typically include payments covering principal and interest, paying down just the interest, or paying a minimum amount that does not even cover the interest.

Opting to pay the minimum amount or just the interest might sound appealing. However, it’s worth remembering that you will have to pay the lender back everything by the date specified in the contract and that interest charges are higher when the principal isn’t getting paid off. If you persist with paying off little, then you’ll find your debt keeps growing—perhaps to unmanageable levels.

Advantages and Disadvantages of ARMs

Adjustable-rate mortgages come with many benefits and drawbacks. We’ve listed some of the most common ones below.

Advantages

The most obvious advantage is that a low rate, especially the intro or teaser rate, will save you money. Not only will your monthly payment be lower than most traditional fixed-rate mortgages, you may also be able to put more down toward your principal balance. Just ensure your lender doesn’t charge you a prepayment fee if you do.

ARMs are great for people who want to finance a short-term purchase, such as a starter home. Or you may want to borrow using an ARM to finance the purchase of a home that you intend to flip. This allows you to pay lower monthly payments until you decide to sell again.

More money in your pocket with an ARM also means you have more in your pocket to put toward savings or other goals, such as a vacation or a new car.

Unlike fixed-rate borrowers, you won’t have to make a trip to the bank or your lender to refinance when interest rates drop. That’s because you’re probably already getting the best deal available.

Disadvantages

One of the major cons of ARMs is that the interest rate will change. This means that if market conditions lead to a rate hike, you’ll end up spending more on your monthly mortgage payment. And that can put a dent in your monthly budget.

ARMs may offer you flexibility but they don’t provide you with any predictability as fixed-rate loans do. Borrowers with fixed-rate loans know what their payments will be throughout the life of the loan because the interest rate never changes. But because the rate changes with ARMs, you’ll have to keep juggling your budget with every rate change.

These mortgages can often be very complicated to understand, even for the most seasoned borrower. There are various features that come with these loans that you should be aware of before you sign your mortgage contracts, such as caps, indexes, and margins.

How the Variable Rate on ARMs Is Determined

At the end of the initial fixed-rate period, ARM interest rates will become variable (adjustable) and will fluctuate based on some reference interest rate (the ARM index) plus a set amount of interest above that index rate (the ARM margin). The ARM index is often a benchmark rate such as the prime rate, the LIBOR, the Secured Overnight Financing Rate (SOFR), or the rate on short-term U.S. Treasuries.

Although the index rate can change, the margin stays the same. For example, if the index is 5% and the margin is 2%, the interest rate on the mortgage adjusts to 7%. However, if the index is at only 2% the next time that the interest rate adjusts, the rate falls to 4% based on the loan’s 2% margin.

Adjustable-Rate Mortgage vs. Fixed Interest Mortgage

Unlike ARMs, traditional or fixed-rate mortgages carry the same interest rate for the life of the loan, which might be 10, 20, 30, or more years. They generally have higher interest rates at the outset than ARMs, which can make ARMs more attractive and affordable, at least in the short term. However, fixed-rate loans provide the assurance that the borrower’s rate will never shoot up to a point where loan payments may become unmanageable.

With a fixed-rate mortgage, monthly payments remain the same, although the amounts that go to pay interest or principal will change over time, according to the loan’s amortization schedule.

If interest rates in general fall, then homeowners with fixed-rate mortgages can refinance, paying off their old loan with one at a new, lower rate.

Is an ARM Right for You?

An ARM can be a smart financial choice if you are planning to keep the loan for a limited period of time and will be able to handle any rate increases in the meantime. Put simply, an adjustable-rate mortgage is well suited for the following types of borrowers:

• People who intend to hold the loan for a short period of time
• Individuals who expect to see a positive change in their income
• Anyone who can and will pay off the mortgage within a short time frame

In many cases, ARMs come with rate caps that limit how much the rate can rise at any given time or in total. Periodic rate caps limit how much the interest rate can change from one year to the next, while lifetime rate caps set limits on how much the interest rate can increase over the life of the loan.

Notably, some ARMs have payment caps that limit how much the monthly mortgage payment can increase, in dollar terms. That can lead to a problem called negative amortization if your monthly payments aren’t sufficient to cover the interest rate that your lender is changing. With negative amortization, the amount that you owe can continue to increase, even as you make the required monthly payments.

The Bottom Line

Borrowers have many options available to them when they want to finance the purchase of their home or another type of property. You can choose between a fixed-rate or adjustable-rate mortgage. While the former provides you with some predictability, ARMs offer lower interest rates for a certain period of time before they begin to fluctuate with market conditions. There are different types of ARMs to choose from and they have pros and cons. But keep in mind that these kinds of loans are better suited for certain kinds of borrowers, including those who intend to hold onto a property for the short term or if they intend to pay off the loan before the adjusted period begins. If you’re unsure, talk to a financial expert about your options.

What Is the Accounting Rate of Return (ARR)?

The accounting rate of return (ARR) is a formula that reflects the percentage rate of return expected on an investment or asset, compared to the initial investment’s cost. The ARR formula divides an asset’s average revenue by the company’s initial investment to derive the ratio or return that one may expect over the lifetime of an asset or project. ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining a business.

Understanding the Accounting Rate of Return (ARR)

The accounting rate of return is a capital budgeting metric that’s useful if you want to calculate an investment’s profitability quickly. Businesses use ARR primarily to compare multiple projects to determine the expected rate of return of each project, or to help decide on an investment or an acquisition.

ARR factors in any possible annual expenses, including depreciation, associated with the project. Depreciation is a helpful accounting convention whereby the cost of a fixed asset is spread out, or expensed, annually during the useful life of the asset. This lets the company earn a profit from the asset right away, even in its first year of service.

The Formula for ARR

The formula for the accounting rate of return is as follows:

$ARR = \frac{Average\, Annual\, Profit}{Initial\, Investment}$ARR=InitialInvestmentAverageAnnualProfit​

How to Calculate the Accounting Rate of Return (ARR)

1. Calculate the annual net profit from the investment, which could include revenue minus any annual costs or expenses of implementing the project or investment.
2. If the investment is a fixed asset such as property, plant, and equipment (PP&E), subtract any depreciation expense from the annual revenue to achieve the annual net profit.
3. Divide the annual net profit by the initial cost of the asset or investment. The result of the calculation will yield a decimal. Multiply the result by 100 to show the percentage return as a whole number.

Example of the Accounting Rate of Return (ARR)

As an example, a business is considering a project that has an initial investment of $250,000 and forecasts that it would generate revenue for the next five years. Here’s how the company could calculate the ARR:

• Initial investment: $250,000
• Expected revenue per year: $70,000
• Time frame: 5 years
• ARR calculation: $70,000 (annual revenue) / $250,000 (initial cost)
• ARR = 0.28 or 28%

Accounting Rate of Return vs. Required Rate of Return

The ARR is the annual percentage return from an investment based on its initial outlay of cash. Another accounting tool, the required rate of return (RRR), also known as the hurdle rate, is the minimum return an investor would accept for an investment or project that compensates them for a given level of risk.

The RRR can vary between investors as they each have a different tolerance for risk. For example, a risk-averse investor likely would require a higher rate of return to compensate for any risk from the investment. It’s important to utilize multiple financial metrics including ARR and RRR to determine if an investment would be worthwhile based on your level of risk tolerance.

Advantages and Disadvantages of the Accounting Rate of Return (ARR)

Advantages

The accounting rate of return is a simple calculation that does not require complex math and is helpful in determining a project’s annual percentage rate of return. Through this, it allows managers to easily compare ARR to the minimum required return. For example, if the minimum required return of a project is 12% and ARR is 9%, a manager will know not to proceed with the project.

ARR comes in handy when investors or managers need to quickly compare the return of a project without needing to consider the time frame or payment schedule but rather just the profitability or lack thereof.

Disadvantages

Despite its advantages, ARR has its limitations. It doesn’t consider the time value of money. The time value of money is the concept that money available at the present time is worth more than an identical sum in the future because of its potential earning capacity.

In other words, two investments might yield uneven annual revenue streams. If one project returns more revenue in the early years and the other project returns revenue in the later years, ARR does not assign a higher value to the project that returns profits sooner, which could be reinvested to earn more money.

The accounting rate of return does not consider the increased risk of long-term projects and the increased uncertainty associated with long periods.

Also, ARR does not take into account the impact of cash flow timing. Let’s say an investor is considering a five-year investment with an initial cash outlay of $50,000, but the investment doesn’t yield any revenue until the fourth and fifth years.

In this case, the ARR calculation would not factor in the lack of cash flow in the first three years, while in reality, the investor would need to be able to withstand the first three years without any positive cash flow from the project.

The Bottom Line

The accounting rate of return (ARR) is a simple formula that allows investors and managers to determine the profitability of an asset or project. Because of its ease of use and determination of profitability, it is a handy tool in making decisions. However, the formula does not take into consideration the cash flows of an investment or project, the overall timeline of return, and other costs, which help determine the true value of an investment or project.

DEFINITION of 90-Day Letter

90-Day Letter is an IRS notice stating that there was a discrepancy or error within an individual’s taxes and they will be assessed unless petitioned. The taxpayer has 90 days to respond, otherwise the audit deficiencies will result in reassessment. Also known as a Notice of Deficiency. 

BREAKING DOWN 90-Day Letter

Once you receive your notice, you have 90 days (150 days if the notice is addressed to a person who is outside the country) from the date of the notice to file a petition with the Tax Court, if you want to challenge the tax the IRS proposed, according to the agency. These notices are usually sent after or audit, in the case of people who fail to file a tax return or who have unreported income.

What The Notice Means

If you don’t dispute the accuracy of the assessment the Internal Revenue Service has made, you won’t need to amend your tax return unless you have additional income, expenses, or credits that you want to report. In that case, all you need to do is sign Form 5564, Notice of Deficiency and return it to the IRS with a check attached to avoid additional interest and or penalties.

If you agree with the findings but have additional income, expenses, or credits to claim, it will be necessary to amend your original tax return with Form 1040-X. You can do this through your online tax prep service or your tax professional or fill out the form yourself.

It gets more complicated if you disagree with the IRS findings. If you think the IRS notice is incorrect, incomplete or otherwise mistaken, you can contact them with additional information that will shed light on the case. You have 90 days from the date of the notice to dispute the claim. You can ask the Tax Court to reassess or correct or eliminate the liability proposed by the deficiency notice. During the 90 days and any period the case is being reconsidered the IRS by law can’t assess or put your account into collection.

Many taxpayers use a tax professional or attorney to handle the dispute process if the amount in question is significant. 

If you lose the appeal and don’t or can’t pay, the government can file a federal tax lien against your wages, personal property, or your bank account. This is a claim against the assets, not the seizure of them. That happens when a federal tax levy occurs and the IRS actually seizes your property. Payment plans can also be worked out to avoid liens and seizure.

What Is an 8-K?

An 8-K is a report of unscheduled material events or corporate changes at a company that could be of importance to the shareholders or the Securities and Exchange Commission (SEC). Also known as a Form 8K, the report notifies the public of events, including acquisitions, bankruptcy, the resignation of directors, or changes in the fiscal year.

Understanding Form 8-K

An 8-K is required to announce significant events relevant to shareholders. Companies usually have four business days to file an 8-K for most specified items.

Documents fulfilling Regulation Fair Disclosure (Reg FD) requirements may be due before four business days have passed. An organization must determine if the information is material and submit the report to the SEC. The SEC makes the reports available through the Electronic Data Gathering, Analysis, and Retrieval (EDGAR) platform.

The SEC outlines the various situations that require Form 8-K. There are nine sections within the Investor Bulletin. Each of these sections may have anywhere from one to eight subsections. The most recent permanent change to Form 8-K disclosure rules occurred in 2004.

Benefits of Form 8-K

First and foremost, Form 8-K provides investors with timely notification of significant changes at listed companies. Many of these changes are defined explicitly by the SEC. In contrast, others are simply events that firms consider to be sufficiently noteworthy. In any case, the form provides a way for firms to communicate directly with investors. The information provided is not filtered or altered by media organizations in any way. Furthermore, investors do not have to watch TV programs, subscribe to magazines, or even wade through financial news websites to get the 8-K.

Form 8-K also provides substantial benefits to listed companies. By filing an 8-K in a timely fashion, the firm’s management can meet specific disclosure requirements and avoid insider trading allegations. Companies may also use Form 8-K to notify investors of any events that they consider to be important.

Finally, Form 8-K provides a valuable record for economic researchers. For example, academics might wonder what influence various events have on stock prices. It is possible to estimate the impact of these events using regressions, but researchers need reliable data. Because 8-K disclosures are legally required, they provide a complete record and prevent sample selection bias.

Criticism of Form 8-K

Like any legally required paperwork, Form 8-K imposes costs on businesses. There is the cost of preparing and submitting the forms, as well as possible penalties for failing to file on time. Although it is only one small part of the problem, the need to file Form 8-K also deters small companies from going public in the first place. Requiring companies to provide information helps investors make better choices. However, it can reduce their investment options when the burden on businesses becomes too high.

Requirements for Form 8-K

The SEC requires disclosure for numerous changes relating to a registrant’s business and operations. Changes to a material definitive agreement or the bankruptcy of an entity must be reported. Other financial information disclosure requirements include the completion of an acquisition, changes in the firm’s financial condition, disposal activities, and substantial impairments. The SEC mandates filing an 8-K for the delisting of a stock, failure to meet listing standards, unregistered sales of securities, and material modifications to shareholder rights.

An 8-K is required when a business changes accounting firms used for certification. Changes in corporate governance, such as control of the registrant or amendments to articles of incorporation, need to be reported. Changes in the fiscal year and modifications of the registrant’s code of ethics must also be disclosed.

The SEC also requires a report upon the election, appointment, or departure of a director or specific officers. Form 8-K must be used to report changes related to asset-backed securities. The form may also be used to meet Regulation Fair Disclosure requirements.

Form 8-K reports may be issued based on other events up to the company’s discretion that the registrant considers to be of importance to shareholders.